Within Entry S, the valuation of the initial noncontrolling interest and the portion of the

Consolidated Financial Statements—Intra-Entity Asset Transactions 209 Downstream Transfers Upstream Transfers Entry C Entry C Investment in Bottom . . . . 6,000 Investment in Bottom . . . . . . 2,800 Retained Earnings, Retained Earnings, 1111—Top . . . . . . 6,000 1111—Bottom . . . . . 2,800 To convert 1111 initial To convert 1111 initial value figures to the equity value figures to the equity method. Income accrual method. Income accrual is is 80 of 10,000 increase 80 of 6,000 increase in in Retained Earnings less Retained Earnings after 2,500 amortization. removal of unrealized gross profit and 2,500 amortization. Entry S Entry S Common stock— Common stock— Bottom . . . . . . . . . . . . . . 150,000 Bottom . . . . . . . . . . . . . . . . 150,000 Retained Earnings, Retaining Earnings, 1111—Bottom . . . . . . . 310,000 1111—Bottom as Investment in adjusted . . . . . . . . . . . . 306,000 Bottom 80 . . . . 368,000 Investment in Noncontrolling Bottom 80 . . . . . . 364,800 interest—1111 Noncontrolling 20 . . . . . . . . . . 92,000 interest—1111 20 . . . . . . . . . . . . 91,200 To remove subsidiary’s To remove subsidiary’s stockholders’ equity stockholders’ equity accounts accounts and portion of as adjusted in Entry G and investment balance. Book portion of investment balance. value at beginning of year Adjusted book value at begin- is appropriate. ning of year is appropriate. Noncontrolling Interest in Subsidiary’s Noncontrolling Interest in Subsidiary’s Income ⫽ 13,500. 20 of Bottom’s Income ⫽ 13,100. 20 of Bottom’s earned reported income less excess income reported income after adjustment for database amortization. unrealized gross profits and excess database amortization. Effects of Alternative Investment Methods on Consolidation Exhibits 5.3 and 5.4 utilized the initial value method. However, when using either the equity method or the partial equity method, consolidation procedures normally continue to follow the same patterns analyzed in the previous chapters of this textbook. As described earlier, though, a variation in Entry G is required when the equity method is applied and downstream transfers have occurred. The equity in subsidiary earnings account is decreased rather than recording a reduction in the beginning retained earnings of the parentseller with the remaining amount in equity in subsidiary earnings eliminated in Entry I. Otherwise, the specific accounting method in use creates no unique impact on the consolidation process for intra-entity transactions. The major complication when the parent uses the equity method is not always related to a consolidation procedure. Frequently, the composition of the investment-related balances appearing on the parent’s separate financial records proves to be the most complex element of the entire process. Under the equity method, the investment-related accounts are subjected to 1 income accrual, 2 amortization, 3 dividends, and 4 adjustments required by unrealized intra-entity gains. Thus, if Top Company applies the equity method and the transfers are downstream, the Investment in Bottom Company account increases from 400,000 to 414,000 by the end of 2011. For that year, the Equity in Earnings of Bottom Company account registers a 52,000 balance. Both of these totals result from the accounting shown in Exhibit 5.5. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 210 Discussion Question WHAT PRICE SHOULD WE CHARGE OURSELVES? Slagle Corporation is a large manufacturing organization. Over the past several years, it has obtained an important component used in its production process exclusively from Harrison, Inc., a relatively small company in Topeka, Kansas. Harrison charges 90 per unit for this part: Variable cost per unit . . . . . . . . . . . . . . . . . . . . . . 40 Fixed cost assigned per unit . . . . . . . . . . . . . . . . . 30 Markup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Total price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 In hope of reducing manufacturing costs, Slagle purchases all of Harrison’s outstanding common stock. This new subsidiary continues to sell merchandise to a number of outside customers as well as to Slagle. Thus, for internal reporting purposes, Slagle views Harrison as a separate profit center. A controversy has now arisen among company officials about the amount that Harrison should charge Slagle for each component. The administrator in charge of the subsidiary wants to continue the 90 price. He believes this figure best reflects the division’s prof- itability: “If we are to be judged by our profits, why should we be punished for selling to our own parent company? If that occurs, my figures will look better if I forget Slagle as a customer and try to market my goods solely to outsiders.” In contrast, the vice president in charge of Slagle’s production wants the price set at variable cost, total cost, or some derivative of these numbers. “We bought Harrison to bring our costs down. It only makes sense to reduce the transfer price; otherwise the benefits of acquiring this subsidiary are not apparent. I pushed the company to buy Harrison; if our operating results are not improved, I will get the blame.” Will the decision about the transfer price affect consolidated net income? Which method would be easiest for the company’s accountant to administer? As the company’s accountant, what advice would you give to these officials? EXHIBIT 5.5 Investment Balances— Equity Method— Downstream Sales Investment in Bottom Company Analysis 1110 to 123111 Consideration paid fair value 1110 . . . . . . . . . . . . . . . . . . . . . . 400,000 Bottom Co. reported income for 2010 . . . . . . . . . . . . . . . . . . . 30,000 Database amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Bottom Co. adjusted 2010 net income . . . . . . . . . . . . . . . . . . . 27,500 Top’s ownership percentage . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Top’s share of Bottom income . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000 Deferred profit from Top’s 2010 downstream sales . . . . . . . . . . 4,000 Equity in earnings of Bottom Company, 2010 . . . . . . . . . . . . . . . 18,000 Top’s share of Bottom Co. dividends, 2010 80 . . . . . . . . . . . . 16,000 Balance 123110 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402,000 Bottom Co. reported income for 2011 . . . . . . . . . . . . . . . . . . . 70,000 Database amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Bottom Co. adjusted 2011 net income . . . . . . . . . . . . . . . . . . . 67,500 Top’s ownership percentage . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Top’s share of Bottom income . . . . . . . . . . . . . . . . . . . . . . . . . . 54,000 Recognized profit from Top’s 2010 downstream sales . . . . . . . 4,000 Deferred profit from Top’s 2011 downstream sales . . . . . . . . . . 6,000 Equity in earnings of Bottom Company, 2011 . . . . . . . . . . . . . . . 52,000 Top’s share of Bottom Company dividends, 2011 80 . . . . . . . 40,000 Balance 123111 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 414,000 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 211 EXHIBIT 5.6 Investment Balances— Equity Method— Upstream Sales Investment in Bottom Company Analysis 1110 to 123111 Consideration paid fair value 1110 . . . . . . . . . . . . . . . . . . . . . . 400,000 Bottom Co. reported income for 2010 . . . . . . . . . . . . . . . . . . . 30,000 Database amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Deferred profit from Bottom’s 2010 upstream sales . . . . . . . . . 4,000 Bottom Co. adjusted 2010 net income . . . . . . . . . . . . . . . . . . . 23,500 Top’s ownership percentage . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Equity in earnings of Bottom Company, 2010 . . . . . . . . . . . . . . . 18,800 Top’s share of Bottom Company dividends, 2010 80 . . . . . . . 16,000 Balance 123110 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402,800 Bottom Co. reported income for 2011 . . . . . . . . . . . . . . . . . . . 70,000 Database amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500 Recognized profit from Bottom’s 2010 upstream sales . . . . . . . 4,000 Deferred profit from Bottom’s 2011 upstream sales . . . . . . . . . 6,000 Bottom Co. adjusted 2011 net income . . . . . . . . . . . . . . . . . . . 65,500 Top’s ownership percentage . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Equity in earnings of Bottom Company, 2011 . . . . . . . . . . . . . . . 52,400 Top’s share of Bottom Company dividends, 2011 80 . . . . . . . 40,000 Balance 123111 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415,200 If transfers are upstream, the individual investment-related accounts that the parent reports can be determined in the same manner as in Exhibit 5.5. Because of the change in direction, the gross profits are now attributed to the subsidiary. Thus, both accounts related to the investment in Bottom hold balances that vary from the totals computed earlier. The Investment in Bottom Company balance becomes 415,200, whereas the Equity in Earnings of Bottom Company account for the year is 52,400. The differences result from having upstream rather than downstream transfers. The components of these accounts are identified in Exhibit 5.6. Consolidated worksheets for downstream and upstream inventory transfers when Top uses the equity method are shown in Exhibit 5.7 and Exhibit 5.8. Special Equity Method Procedures for Unrealized Intra-Entity Profits from Downstream Transfers Exhibit 5.5 shows an analysis of the parent’s equity method investment accounting procedures in the presence of unrealized intra-entity gross profits resulting from downstream inventory transfers. This application of the equity method differs from that presented in Chapter 1 for a significant influence typically 20 to 50 percent ownership investment. For significant influence investments, an investor company defers unrealized intra-entity gross profits only to the extent of its percentage ownership, regardless of whether the profits resulted from upstream or downstream transfers. In contrast, Exhibit 5.5 shows a 100 percent deferral in 2010, with a subsequent 100 percent recognition in 2011, for intra-entity gross profits resulting from Top’s inventory transfers to Bottom, its 80 percent owned subsidiary. Why the distinction? Because when control rather than just significant influence exists, 100 percent of all intra-entity gross profits are eventually removed from consolidated net income regardless of the direction of the underlying sale. The 100 percent intra-entity profit deferral on Top’s books for downstream sales explicitly recognizes that none of the deferral will be allocated to the noncontrolling interest. As discussed previously, when the parent is the seller in an intra-entity transfer, little justification exists for it to allocate a portion of the gross profit deferral to the noncontrolling interest. In contrast, for an upstream sale, the subsidiary recognizes the gross profit on its books. Because the noncontrolling interest owns a portion of the subsidiary but not of the parent, allocation of intra-entity gross profit de- ferrals and subsequent recognitions across the noncontrolling interest and the parent appear appropriate. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 212 Chapter 5 EXHIBIT 5.7 Downstream Inventory Transfers TOP COMPANY AND BOTTOM COMPANY Consolidation: Acquisition Method Consolidation Worksheet Investment: Equity Method For Year Ending December 31, 2011 Ownership: 80 Consolidation Entries Top Bottom Noncontrolling Consolidated Accounts Company Company Debit Credit Interest Totals Income Statement Sales 600,000 300,000 TI100,000 800,000 Cost of goods sold 320,000 180,000 G 6,000 G 4,000 402,000 TI 100,000 Operating expenses 170,000 50,000 E 2,500 222,500 Equity in earnings of Bottom 52,000 G 4,000 I 48,000 ‡ –0– Separate company net income 162,000 70,000 Consolidated net income 175,500 Noncontrolling interest in Bottom Company’s income 13,500 † 13,500 Top’s interest in consolidated income 162,000 Statement of Retained Earnings Retained earnings 1111 Top Company 652,000 652,000 Bottom Company 310,000 S310,000 Net income above 162,000 70,000 162,000 Dividends paid 70,000 50,000 D 40,000 10,000 70,000 Retained earnings 123111 744,000 330,000 744,000 Balance Sheet Cash and receivables 280,000 120,000 P 10,000 390,000 Inventory 220,000 160,000 G 6,000 374,000 Investment in Bottom 414,000 D 40,000 I 48,000 368,000 –0– A 38,000 Land 410,000 200,000 610,000 Plant assets net 190,000 170,000 360,000 Database A 47,500 E 2,500 45,000 Total assets 1,514,000 650,000 1,779,000 Liabilities 340,000 170,000 P 10,000 500,000 Noncontrolling interest in Bottom Company, 1111 S 92,000 A 9,500 101,500 Noncontrolling interest in Bottom Company, 123111 105,000 105,000 Common stock 430,000 150,000 S150,000 430,000 Retained earnings 123111 above 744,000 330,000 744,000 Total liabilities and equities 1,514,000 650,000 718,000 718,000 1,779,000 Note: Parentheses indicate a credit balance. †Because intra-entity sales are made downstream by the parent, the subsidiary’s earned income is the 70,000 reported less 2,500 excess amortization figure with a 20 allocation to the noncontrolling interest 13,500. ‡Boxed items highlight differences with upstream transfers examined in Exhibit 5.8. Consolidation entries: G Removal of unrealized gross profit from beginning figures so that it can be recognized in current period. Downstream sales attributed to parent. S Elimination of subsidiary’s stockholders’ equity accounts along with recognition of January 1, 2011, noncontrolling interest. A Allocation of excess fair value over subsidiary’s book value, unamortized balance as of January 1, 2011. I Elimination of intra-entity income remaining after G elimination. D Elimination of intra-entity dividend. E Recognition of amortization expense for current year on excess fair value allocated to database. P Elimination of intra-entity receivablepayable balances. TI Elimination of intra-entity salespurchases balances. G Removal of unrealized gross profit from ending figures so that it can be recognized in subsequent period. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 213 EXHIBIT 5.8 Upstream Inventory Transfers TOP COMPANY AND BOTTOM COMPANY Consolidation: Acquisition Method Consolidation Worksheet Investment: Equity Method For Year Ending December 31, 2011 Ownership: 80 Consolidation Entries Top Bottom Noncontrolling Consolidated Accounts Company Company Debit Credit Interest Totals Income Statement Sales 600,000 300,000 TI100,000 800,000 Cost of goods sold 320,000 180,000 G 6,000 G 4,000 402,000 TI100,000 Operating expenses 170,000 50,000 E 2,500 222,500 Equity in earnings of Bottom 52,400 I 52,400 ‡ Separate company net income 162,400 70,000 Consolidated net income 175,500 Noncontrolling interest in Bottom Company’s income 13,100 † 13,100 Top’s interest in consolidated net income 162,400 Statement of Retained Earnings Retained earnings 1111 Top Company 652,800 652,800 Bottom Company 310,000 G 4,000 S306,000 Net income above 162,400 70,000 162,400 Dividends paid 70,000 50,000 D 40,000 10,000 70,000 Retained earnings 123111 745,200 330,000 745,200 Balance Sheet Cash and receivables 280,000 120,000 P 10,000 390,000 Inventory 220,000 160,000 G 6,000 374,000 Investment in Bottom 415,200 D 40,000 I 52,400 –0– S364,800 A 38,000 Land 410,000 200,000 610,000 Plant assets net 190,000 170,000 360,000 Database A 47,500 E 2,500 45,000 Total assets 1,515,200 650,000 1,779,000 Liabilities 340,000 170,000 P 10,000 500,000 Noncontrolling interest in Bottom Company, 1111 S 91,200 A 9,500 100,700 Noncontrolling interest in Bottom Company, 123111 103,800 103,800 Common stock 430,000 150,000 S150,000 430,000 Retained earnings 123111 above 745,200 330,000 745,200 Total liabilities and equities 1,515,200 650,000 718,400 718,400 1,779,000 Note: Parentheses indicate a credit balance. †Because intra-entity sales were upstream, the subsidiary’s 70,000 income is decreased for the 6,000 gross profit deferred into next year and increased for 4,000 gross profit deferred from the previous year. After further reduction for 2,500 excess amortization, the resulting 65,500 provides the noncontrolling interest with a 13,100 allocation 20. ‡Boxed items highlight differences with downstream transfers examined in Exhibit 5.7. Consolidation entries: G Removal of unrealized gross profit from beginning figures so that it can be recognized in current period. Upstream sales attributed to subsidiary. S Elimination of adjusted stockholders’ equity accounts along with recognition of January 1, 2011, noncontrolling interest. A Allocation of excess fair value over subsidiary’s book value, unamortized balance as of January 1, 2011. I Elimination of intra-entity income. D Elimination of intra-entity dividends. E Recognition of amortization expense for current year on database. P Elimination of intra-entity receivablepayable balances. TI Elimination of intra-entity salespurchases balances. G Removal of unrealized gross profit from ending figures so that it can be recognized in subsequent period. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com INTRA-ENTITY LAND TRANSFERS Although not as prevalent as inventory transactions, intra-entity sales of other assets occur occasionally. The final two sections of this chapter examine the worksheet procedures that noninventory transfers necessitate. We first analyze land transactions and then discuss the effects created by the intra-entity sale of depreciable assets such as buildings and equipment. Accounting for Land Transactions The consolidation procedures necessitated by intra-entity land transfers partially parallel those for intra-entity inventory. As with inventory, the sale of land creates a series of effects on the individual records of the two companies. The worksheet process must then adjust the account balances to present all transactions from the perspective of a single economic entity. By reviewing the sequence of events occurring in an intra-entity land sale, the similarities to inventory transfers can be ascertained as well as the unique features of this transaction. 1. The original seller of the land reports a gain losses are rare in intra-entity asset transfers, even though the transaction occurred between related parties. At the same time, the acquiring company capitalizes the inflated transfer price rather than the land’s historical cost to the business combination. 2. The gain the seller recorded is closed into Retained Earnings at the end of the year. From a consolidated perspective, this account has been artificially increased by a related party. Thus, both the buyer’s Land account and the seller’s Retained Earnings account continue to contain the unrealized profit. 3. The gain on the original transfer is actually earned only when the land is subsequently disposed of to an outside party. Therefore, appropriate consolidation techniques must be designed to eliminate the intra-entity gain each period until the time of resale. Clearly, two characteristics encountered in inventory transfers also exist in intra-entity land transactions: inflated book values and unrealized gains subsequently culminated through sales to outside parties. Despite these similarities, significant differences exist. Because of the nature of the transaction, the individual companies do not use salespurchases accounts when land is transferred. Instead, the seller establishes a separate gain account when it removes the land from its books. Because this gain is unearned, the balance has to be eliminated when preparing consolidated statements. In addition, the subsequent resale of land to an outside party does not always occur in the year immediately following the transfer. Although inventory is normally disposed of within a relatively short time, the buyer often holds land for years if not permanently. Thus, the overvalued Land account can remain on the acquiring company’s books indefinitely. As long as the land is retained, elimination of the effects of the unrealized gain the equivalent of Entry G in inventory transfers must be made for each subsequent consolidation. By repeating this worksheet entry every year, the consolidated financial statements properly state both the Land and the Retained Earnings accounts. Eliminating Unrealized Gains—Land Transfers To illustrate these worksheet procedures, assume that Hastings Company and Patrick Com- pany are related parties. On July 1, 2011, Hastings sold land that originally cost 60,000 to Patrick at a 100,000 transfer price. The seller reports a 40,000 gain; the buyer records the land at the 100,000 acquisition price. At the end of this fiscal period, the intra-entity effect of this transaction must be eliminated for consolidation purposes: Consolidation Entry TL year of transfer Gain on Sale of Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 To eliminate effects of intra-entity transfer of land. Labeled “TL” in reference to the transferred land. 214 Chapter 5 LO6 Prepare the consolidation entry to remove any unrealized gain created by the intra-entity transfer of land from the accounting records of the year of transfer and subsequent years. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 215 This worksheet entry eliminates the unrealized gain from the 2011 consolidated statements and returns the land to its recorded value at date of transfer, for consolidated purposes. However, as with the transfer of inventory, the effects created by the original transaction remain in the financial records of the individual companies for as long as the property is held. The gain recorded by Hastings carries through to Retained Earnings while Patrick’s Land account retains the inflated transfer price. Therefore, for every subsequent consolidation until the land is eventually sold, the elimination process must be repeated. Including the following entry on each subsequent worksheet removes the unrealized gain from the asset and from the earnings reported by the combination: Consolidation Entry GL every year following transfer Retained Earnings beginning balance of seller . . . . . . . . . . . . . . . . . . . . . . 40,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 To eliminate effects of intra-entity transfer of land made in a previous year. Labeled “ GL” in reference to the gain on a land transfer occurring in a prior year. Note that the reduction in Retained Earnings is changed to an increase in the investment account when the original sale is downstream and the parent has applied the equity method. In that specific situation, equity method adjustments have already corrected the timing of the parent’s unrealized gain. Removing the gain has created a reduction in the investment account that is appropriately allocated to the subsidiary’s Land account on the worksheet. Conversely, if sales were upstream, the Retained Earnings of the seller the subsidiary continue to be over- stated even if the parent applies the equity method. One final consolidation concern exists in accounting for intra-entity transfers of land. If the property is ever sold to an outside party, the company making the sale records a gain or loss based on its recorded book value. However, this cost figure is actually the internal transfer price. The gain or loss being recognized is incorrect for consolidation purposes; it has not been computed by comparison to the land’s historical cost. Again, the separate financial records fail to reflect the transaction from the perspective of the single economic entity. Therefore, if the company eventually sells the land, it must recognize the gain deferred at the time of the original transfer. It has finally earned this profit by selling the property to outsiders. On the worksheet, the gain is removed one last time from beginning Retained Earnings or the investment account, if applicable. In this instance, though, the entry is completed by reclassi- fying the amount as a realized gain. The timing of income recognition has been switched from the year of transfer into the fiscal period in which the land is sold to the unrelated party. Returning to the previous illustration, Hastings acquired land for 60,000 and sold it to Patrick, a related party, for 100,000. Consequently, the 40,000 unrealized gain was eliminated on the consolidation worksheet in the year of transfer as well as in each succeeding period. How- ever, if this land is subsequently sold to an outside party for 115,000, Patrick recognizes only a 15,000 gain. From the viewpoint of the business combination, the land having been bought for 60,000 was actually sold at a 55,000 gain. To correct the reporting, the following consolidation entry must be made in the year that the property is sold to the unrelated party. This adjustment increases the 15,000 gain recorded by Patrick to the consolidated balance of 55,000: Consolidation Entry GL year of sale to outside party Retained Earnings Hastings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Gain on Sale of Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 To remove intra-entity gain from year of transfer so that total profit can be recognized in the current period when land is sold to an outside party. As in the accounting for inventory transfers, the entire consolidation process demonstrated here accomplishes two major objectives: 1. Reports historical cost for the transferred land for as long as it remains within the business combination. 2. Defers income recognition until the land is sold to outside parties. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Recognizing the Effect on Noncontrolling Interest Valuation—Land Transfers The preceding discussion of intra-entity land transfers ignores the possible presence of a noncontrolling interest. In constructing financial statements for an economic entity that includes outside ownership, the guidelines already established for inventory transfers remain applicable. If the original sale was a downstream transaction, neither the annual deferral nor the eventual recognition of the unrealized gain has any effect on the noncontrolling interest. The ratio- nale for this treatment, as previously indicated, is that profits from downstream transfers relate solely to the parent company. Conversely, if the transfer is made upstream, deferral and recognition of gains are attributed to the subsidiary and, hence, to the valuation of the noncontrolling interest. As with inventory, all noncontrolling interest balances are computed on the reported earnings of the subsidiary after adjustment for any upstream transfers. To reiterate, the accounting consequences stemming from land transfers are these: 1. In the year of transfer, any unrealized gain is deferred and the Land account is reduced to historical cost. When an upstream sale creates the gain, the amount also is excluded in calculating the noncontrolling interest’s share of the subsidiary’s net income for that year. 2. Each year thereafter, the unrealized gain will be removed from the seller’s beginning Retained Earnings. If the transfer was upstream, eliminating this earlier gain directly affects the balances recorded within both Entry C if conversion to the equity method is required and Entry S. The additional equity accrual Entry C, if needed as well as the elimination of beginning Stockholders’ Equity Entry S must be based on the newly adjusted balance in the subsidiary’s Retained Earnings. This deferral process also has an impact on the noncontrolling interest’s share of the subsidiary’s income, but only in the year of transfer and the eventual year of sale. 3. If the land is ever sold to an outside party, the original gain is earned and must be reported by the consolidated entity. INTRA-ENTITY TRANSFER OF DEPRECIABLE ASSETS Just as related parties can transfer land, the intra-entity sale of a host of other assets is possible. Equipment, patents, franchises, buildings, and other long-lived assets can be involved. Accounting for these transactions resembles that demonstrated for land sales. However, the subsequent calculation of depreciation or amortization provides an added challenge in the development of consolidated statements. 10 Deferral of Unrealized Gains When faced with intra-entity sales of depreciable assets, the accountant’s basic objective remains unchanged: to defer unrealized gains to establish both historical cost balances and recognize appropriate income within the consolidated statements. More specifically, accountants defer gains created by these transfers until such time as the subsequent use or resale of the asset consummates the original transaction. For inventory sales, the culminating disposal normally occurs currently or in the year following the transfer. In contrast, transferred land is quite often never resold, thus permanently deferring the recognition of the intra-entity profit. For depreciable asset transfers, the ultimate realization of the gain normally occurs in a different manner; the property’s use within the buyer’s operations is reflected through depreciation. Recognition of this expense reduces the asset’s book value every year and, hence, the overvaluation within that balance. The depreciation systematically eliminates the unrealized gain not only from the asset account but also from Retained Earnings. For the buyer, excess expense results each year because the computation is based on the inflated transfer cost. This depreciation is then closed annually into Retained Earnings. From a consolidated perspective, the extra expense gradually 216 Chapter 5 10 To avoid redundancy within this analysis, all further references are made to depreciation expense alone, although this discussion is equally applicable to the amortization of intangible assets and the depletion of wasting assets. LO7 Prepare the consolidation entries to remove the effects of upstream and downstream intra-entity fixed asset transfers across affiliated entities. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 217 11 If the worksheet uses only one account for a net depreciated asset, this entry would have been Gain on sale 30,000 Equipment net 30,000 To reduce the 90,000 to original 60,000 book value at date of transfer rather than reinstating original balances. offsets the unrealized gain within this equity account. In fact, over the life of the asset, the depreciation process eliminates all effects of the transfer from both the asset balance and the Retained Earnings account. Depreciable Asset Transfers Illustrated To examine the consolidation procedures required by the intra-entity transfer of a depreciable asset, assume that Able Company sells equipment to Baker Company at the current market value of 90,000. Able originally acquired the equipment for 100,000 several years ago; since that time, it has recorded 40,000 in accumulated depreciation. The transfer is made on January 1, 2010, when the equipment has a 10-year remaining life. Year of Transfer The 2010 effects on the separate financial accounts of the two companies can be quickly enumerated: 1. Baker, as the buyer, enters the equipment into its records at the 90,000 transfer price. However, from a consolidated view, the 60,000 book value 100,000 cost less 40,000 accumulated depreciation is still appropriate. 2. Able, as the seller, reports a 30,000 profit, although the combination has not yet earned anything. Able then closes this gain into its Retained Earnings account at the end of 2010. 3. Assuming application of the straight-line depreciation method with no salvage value, Baker records expense of 9,000 at the end of 2010 90,000 transfer price10 years. The buyer recognizes this amount rather than the 6,000 depreciation figure applicable to the consolidated entity 60,000 book value10 years. To report these events as seen by the business combination, both the 30,000 unrealized gain and the 3,000 overstatement in depreciation expense must be eliminated on the worksheet. For clarification purposes, two separate consolidation entries for 2010 follow. However, they can be combined into a single adjustment: Consolidation Entry TA year of transfer Gain on Sale of Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 To remove unrealized gain and return equipment accounts to balances based on original historical cost. Labeled “TA” in reference to transferred asset. Consolidation Entry ED year of transfer Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 To eliminate overstatement of depreciation expense caused by inflated transfer price. Labeled “ED” in reference to excess depreciation. Entry must be repeated for all 10 years of the equipment’s life. From the viewpoint of a single entity, these entries accomplish several objectives: 11 • Reinstate the asset’s historical cost of 100,000. • Return the January 1, 2010, book value to the appropriate 60,000 figure by recognizing accumulated depreciation of 40,000. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com • Eliminate the 30,000 unrealized gain recorded by Able so that this intra-entity profit does not appear in the consolidated income statement. • Reduce depreciation for the year from 9,000 to 6,000, the appropriate expense based on historical cost. In the year of the intra-entity depreciable asset transfer, the preceding consolidation entries TA and ED are applicable regardless of whether the transfer was upstream or downstream. They are likewise applicable regardless of whether the parent applies the equity method, initial value method, or partial equity method of accounting for its investment. As discussed subsequently, however, in the years following the intra-entity transfer, a slight modification must be made to the consolidation entry TA when the equity method is applied and the transfer is downstream. Years Following Transfer Again, the preceding worksheet entries do not actually remove the effects of the intra- entity transfer from the individual records of these two organizations. Both the unrealized gain and the excess depreciation expense remain on the separate books and are closed into Retained Earnings of the respective companies at year-end. Similarly, the Equipment account with the related accumulated depreciation continues to hold balances based on the transfer price, not historical cost. Thus, for every subsequent period, the separately reported figures must be adjusted on the worksheet to present the consolidated totals from a single entity’s perspective. To derive worksheet entries at any future point, the balances in the accounts of the individual companies must be ascertained and compared to the figures appropriate for the business combination. As an illustration, the separate records of Able and Baker two years after the transfer December 31, 2011 follow. Consolidated totals are calculated based on the original historical cost of 100,000 and accumulated depreciation of 40,000. Individual Consolidated Worksheet Account Records Perspective Adjustments Equipment 123111 90,000 100,000 10,000 Accumulated Depreciation 123111 18,000 52,000 34,000 Depreciation Expense 123111 9,000 6,000 3,000 1111 Retained Earnings effect 21,000† 6,000 27,000 Note: Parentheses indicate a credit. Accumulated depreciation before transfer 40,000 plus 2 years ⫻ 6,000. † Intra-entity transfer gain 30,000 less one year’s depreciation of 9,000. Because the transfer’s effects continue to exist in the separate financial records, the various accounts must be corrected in each succeeding consolidation. However, the amounts involved must be updated every period because of the continual impact that depreciation has on these balances. As an example, to adjust the individual figures to the consolidated totals derived earlier, the 2011 worksheet must include the following entries: Consolidation Entry TA year following transfer Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Retained Earnings, 1111 Able . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000 Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000 To return the Equipment account to original historical cost and correct the 1111 balances of Retained Earnings and Accumulated Depreciation. 218 Chapter 5 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 219 Consolidation Entry ED year following transfer Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 To remove excess depreciation expense on the intra-entity transfer price and adjust Accumulated Depreciation to its correct 123111 balance. Note that the 34,000 increase in 123111 consolidated Accumulated Depreciation is accomplished by a 37,000 credit in Entry TA and a 3,000 debit in Entry ED. Although adjustments of the asset and depreciation expense remain constant, the change in beginning Retained Earnings and Accumulated Depreciation varies with each succeeding consolidation. At December 31, 2010, the individual companies closed out both the unrealized gain of 30,000 and the initial 3,000 overstatement of depreciation expense. Therefore, as reflected in Entry TA, the beginning Retained Earnings account for 2011 is overvalued by a net amount of only 27,000 rather than 30,000. Over the life of the asset, the unrealized gain in retained earnings will be systematically reduced to zero as excess depreciation expense 3,000 is closed out each year. Hence, on subsequent consolidation worksheets, the beginning Retained Earnings account decreases by this amount: 27,000 in 2011, 24,000 in 2012, and 21,000 in the following period. This reduction continues until the effect of the unrealized gain no longer exists at the end of 10 years. If this equipment is ever resold to an outside party, the remaining portion of the gain is considered earned. As in the previous discussion of land, the intra-entity profit that exists at that date must be recognized on the consolidated income statement to arrive at the appropriate amount of gain or loss on the sale. Depreciable Intra-Entity Asset Transfers—Downstream Transfers When the Parent Uses the Equity Method A slight modification to consolidation entry TA is required when the intra-entity depreciable asset transfer is downstream and the parent uses the equity method. In applying the equity method, the parent adjusts its book income for both the original transfer gain and periodic depreciation expense adjustments. Thus, in downstream intra-entity transfers when the equity method is used, from a consolidated view, the book value of the parent’s Retained Earnings balance has been already reduced for the gain. Therefore, continuing with the previous example, the following worksheet consolidation entries would be made for a downstream sale assuming that 1 Able is the parent and 2 Able has applied the equity method to account for its investment in Baker. Consolidation Entry TA year following transfer Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Investment in Baker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000 Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000 Consolidation Entry ED year following transfer Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 In Entry TA, note that the Investment in Baker account replaces the parent’s Retained Earn- ings. The debit to the investment account effectively allocates the write-down necessitated by the intra-entity transfer to the appropriate subsidiary equipment and accumulated depreciation accounts. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Effect on Noncontrolling Interest Valuation— Depreciable Asset Transfers Because of the lack of official guidance, no easy answer exists as to the assignment of any income effects created within the consolidation process. Consistent with the previous sections of this chapter, all income is assigned here to the original seller. In Entry TA, for example, the beginning Retained Earnings account of Able the seller is reduced. Both the unrealized gain on the transfer and the excess depreciation expense subsequently recognized are assigned to that party. Thus, again, downstream sales are assumed to have no effect on any noncontrolling interest values. The parent rather than the subsidiary made the sale. Conversely, the impact on income created by upstream sales must be considered in computing the balances attributed to these outside owners. Currently, this approach is one of many acceptable alternatives. How- ever, in its future deliberations on consolidation policies and procedures, the FASB could man- date a specific allocation pattern. Summary 1. The transfer of assets, especially inventory, between the members of a business combination is a common practice. In producing consolidated financial statements, any effects on the separate accounting records created by such transfers must be removed because the transactions did not occur with an outside, unrelated party. 2. Inventory transfers are the most prevalent form of intra-entity asset transaction. Despite being only a transfer, one company records a sale while the other reports a purchase. These balances are recipro- cals that must be offset on the worksheet in the process of producing consolidated figures. 3. Additional accounting problems result if inventory is transferred at a markup. Any portion of the merchandise still held at year-end is valued at more than historical cost because of the inflation in price. Furthermore, the gross profit that the seller reports on these goods is unrealized from a consolidation perspective. Thus, this gross profit must be removed from the ending Inventory account, a figure that appears as an asset on the balance sheet and as a negative component within cost of goods sold. 4. Unrealized inventory gross profits also create a consolidation problem in the year following the transfer. Within the separate accounting systems, the seller closes the gross profit to Retained Earnings. The buyer’s ending Inventory balance becomes the next period’s beginning balance within Cost of Goods Sold. Therefore, the inflation must be removed again but this time in the subsequent year. The seller’s beginning Retained Earnings is decreased to eliminate the unrealized gross profit while Cost of Goods Sold is reduced to remove the overstatement from the beginning inventory component. Through this process, the intra-entity profit is deferred from the year of transfer so that recognition can be made at the point of disposal or consumption. 5. The deferral and subsequent realization of intra-entity gross profits raise a question concerning the valuation of noncontrolling interest balances: Does the change in the period of recognition alter these calculations? Although the issue is currently under debate, no formal answer to this question is yet found in official accounting pronouncements. In this textbook, the deferral of profits from upstream transfers from subsidiary to parent is assumed to affect the noncontrolling interest whereas downstream transactions from parent to subsidiary do not. When upstream transfers are involved, noncontrolling interest values are based on the earned figures remaining after adjustment for any unrealized profits. 6. Inventory is not the only asset that can be sold between the members of a business combination. For example, transfers of land sometimes occur. Again, if the price exceeds original cost, the buyer’s records state the asset at an inflated value while the seller recognizes an unrealized gain. As with inventory, the consolidation process must return the asset’s recorded balance to cost while deferring the gain. Repetition of this procedure is necessary in every consolidation for as long as the land remains within the business combination. 7. The consolidation process required by the intra-entity transfer of depreciable assets differs somewhat from that demonstrated for inventory and land. Unrealized gain created by the transaction must still be eliminated along with the asset’s overstatement. However, because of subsequent depreciation, these adjustments systematically change from period to period. Following the transfer, the buyer computes depreciation based on the new inflated transfer price. Thus, an expense that reduces the carrying value of the asset at a rate in excess of appropriate depreciation is recorded; the book value moves closer to the historical cost figure each time that depreciation is recorded. Additionally, because the 220 Chapter 5 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 221 Estimated Time: 45 to 65 Minutes On January 1, 2009, Daisy Company acquired 80 percent of Rose Company for 594,000 in cash. Rose’s total book value on that date was 610,000 and the fair value of the noncontrolling interest was 148,500. The newly acquired subsidiary possessed a trademark 10-year remaining life that, although unrecorded on Rose’s accounting records, had a fair value of 75,000. Any remaining excess acquisition-date fair value was attributed to goodwill. Daisy decided to acquire Rose so that the subsidiary could furnish component parts for the parent’s production process. During the ensuing years, Rose sold inventory to Daisy as follows: Cost to Gross Transferred Inventory Rose Transfer Profit Still Held at End of Year Company Price Rate Year at transfer price 2009 100,000 140,000 28.6 20,000 2010 100,000 150,000 33.3 30,000 2011 120,000 160,000 25.0 68,000 Any transferred merchandise that Daisy retained at a year-end was always put into production during the following period. On January 1, 2010, Daisy sold Rose several pieces of equipment that had a 10-year remaining life and were being depreciated on the straight-line method with no salvage value. This equipment was transferred at an 80,000 price, although it had an original 100,000 cost to Daisy and a 44,000 book value at the date of exchange. On January 1, 2011, Daisy sold land to Rose for 50,000, its fair value at that date. The original cost had been only 22,000. By the end of 2011, Rose had made no payment for the land. The following separate financial statements are for Daisy and Rose as of December 31, 2011. Daisy has applied the equity method to account for this investment. Daisy Company Rose Company Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000 500,000 Cost of goods sold . . . . . . . . . . . . . . . . . . 598,000 300,000 Operating expenses . . . . . . . . . . . . . . . . . . 210,000 80,000 Gain on sale of land . . . . . . . . . . . . . . . . . 28,000 –0– Income of Rose Company . . . . . . . . . . . . . 60,000 –0– Net income . . . . . . . . . . . . . . . . . . . . . . 180,000 120,000 Retained earnings, 1111 . . . . . . . . . . . . . 620,000 430,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . 180,000 120,000 Dividends paid . . . . . . . . . . . . . . . . . . . . . . 55,000 50,000 Retained earnings, 123111 . . . . . . . . . 745,000 500,000 Cash and accounts receivable . . . . . . . . . . 348,000 410,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 430,400 190,000 Investment in Rose Company . . . . . . . . . . 737,600 –0– Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 454,000 280,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . 270,000 190,000 Accumulated depreciation . . . . . . . . . . . . . 180,000 50,000 Total assets . . . . . . . . . . . . . . . . . . . . . . 2,060,000 1,020,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 715,000 120,000 Common stock . . . . . . . . . . . . . . . . . . . . . 600,000 400,000 Retained earnings, 123111 . . . . . . . . . . . 745,000 500,000 Total liabilities and equities . . . . . . . . . . . 2,060,000 1,020,000 Comprehensive Illustration PROBLEM excess depreciation is closed annually to Retained Earnings, the overstatement of the equity account resulting from the unrealized gain is constantly reduced. To produce consolidated figures at any point in time, the remaining inflation in these figures as well as in the current depreciation expense must be determined and removed. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 222 Chapter 5 Required Answer the following questions: a. By how much did Rose’s book value increase during the period from January 1, 2009, through December 31, 2010? b. During the initial years after the takeover, what annual amortization expense was recognized in connection with the acquisition-date excess of fair value over book value? c. What amount of unrealized gross profit exists within the parent’s inventory figures at the beginning and at the end of 2011? d. Equipment has been transferred between the companies. What amount of additional depreciation is recognized in 2011 because of this transfer? e. The parent reports Income of Rose Company of 60,000 for 2011. How was this figure calculated? f. Without using a worksheet, determine consolidated totals. g. Prepare the worksheet entries required at December 31, 2011, by the transfers of inventory, land, and equipment. SOLUTION a. The subsidiary’s book value on the date of purchase was given as 610,000. At the beginning of 2011, the company’s common stock and retained earnings total is 830,000 400,000 and 430,000, respectively. In the previous years, Rose’s book value has apparently increased by 220,000 830,000 ⫺ 610,000. b. To determine amortization, an allocation of Daisy’s acquisition-date fair value must first be made. The 75,000 allocation needed to show Daisy’s equipment at fair value leads to additional annual expense of 7,500 for the initial years of the combination. The 57,500 assigned to goodwill is not subject to amortization. Acquisition-Date Fair-Value Allocation and Excess Amortization Schedule Consideration paid by Daisy for 80 of Rose . . . . . . . . . . . . . . . . . . . . . . 594,000 Noncontrolling interest 20 fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . 148,500 Rose’s fair value at acquisition date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 742,500 Book value of Rose Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610,000 Excess fair value over book value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132,500 Annual Excess Unamortized Life Excess Amortizations Value, Years Amortizations 2009–2011 123111 Trademark . . . . . . . . 75,000 10 7,500 22,500 52,500 Goodwill . . . . . . . . . 57,500 –0– –0– 57,500 Totals . . . . . . . . . . 132,500 7,500 22,500 c. Of the inventory transferred to Daisy during 2010, 30,000 is still held at the beginning of 2011. This merchandise contains an unrealized gross profit of 10,000 30,000 ⫻ 33.3 gross profit rate for that year. At year-end, 17,000 68,000 remaining inventory ⫻ 25 gross profit rate is viewed as an unrealized gross profit. d. Additional depreciation for the net addition of 2011 is 3,600. Equipment with a book value of 44,000 was transferred at a price of 80,000. The net of 36,000 to this asset’s account balances would be written off over 10 years for an extra 3,600 per year during the consolidation process. e. According to the separate statements given, the subsidiary reports net income of 120,000. However, in determining the income allocation between the parent and the noncontrolling interest, this reported figure must be adjusted for the effects of any upstream transfers. Because Rose sold the inventory upstream to Daisy, the 10,000 net profit deferred in requirement c from 2010 into the current period To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 223 is attributed to the subsidiary as the seller. Likewise, the 17,000 unrealized net profit at year-end is viewed as a reduction in Rose’s income. All other transfers are downstream and not considered to have an effect on the subsidiary. There- fore, the Equity Income of Rose Company balance can be verified as follows: Rose Company’s reported income—2011 . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 Recognition of 2010 unrealized gross profit . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Deferral of 2011 unrealized gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 Excess amortization expense—2011 see requirement [b]. . . . . . . . . . . . . . 7,500 Earned income of subsidiary from consolidated perspective . . . . . . . . . . . . 105,500 Parent’s ownership percentage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 Equity income accrual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,400 Adjustments attributed to parent’s ownership Deferral of unrealized gain—land . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 Removal of excess depreciation see requirement [d ] . . . . . . . . . . . . . 3,600 Equity income of Rose Company—2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 f. Each of the 2011 consolidated totals for this business combination can be determined as follows: Sales ⫽ 1,240,000. The parent’s balance is added to the subsidiary’s balance less the 160,000 in intra-entity transfers for the period. Cost of Goods Sold ⫽ 745,000. The computation begins by adding the parent’s balance to the subsidiary’s balance less the 160,000 in intra-entity transfers for the period. The 10,000 unrealized gross profit from the previous year is deducted to recognize this income currently. Next, the 17,000 ending unrealized gross profit is added to cost of goods sold to defer the income until a later year when the goods are sold to an outside party. Operating Expenses ⫽ 293,900. The parent’s balance is added to the subsidiary’s balance. Annual excess fair-value amortization of 7,500 see requirement [b] is also included. Excess depreciation of 3,600 resulting from the transfer of equipment see requirement [e] is removed. Gain on Sale of Land ⫽ –0–. This amount is eliminated for consolidation purposes because the transaction was intra-entity. Income of Rose Company ⫽ –0–. The equity income figure is removed so that the subsidiary’s actual revenues and expenses can be included in the financial statements without double-counting. Noncontrolling Interest in Subsidiary’s Income ⫽ 21,100. Requirement e shows the subsidiary’s earned income from a consolidated perspective as 105,500 after adjustments for unrealized upstream gains and excess fair-value amortization. Because outsiders hold 20 percent of the subsidiary, a 21,100 allocation 105,500 ⫻ 20 is made. Consolidated Net Income ⫽ 201,100 computed as Sales less Cost of Goods Sold and Operating Expenses. The consolidated net income is then distributed: 21,100 to the noncontrolling interest and 180,000 to the parent company owners. Retained Earnings, 1111 ⫽ 620,000. The equity method has been applied; therefore, the parent’s balance equals the consolidated total. Dividends Paid ⫽ 55,000. Only the amount the parent paid is shown in the consolidated statements. Distributions from the subsidiary to the parent are eliminated as intra-entity transfers. Any payment to the noncontrolling interest reduces the ending balance attributed to these outside owners. Cash and Accounts Receivable ⫽ 708,000. The two balances are added after removal of the 50,000 intra-entity receivable created by the transfer of land. Inventory ⫽ 603,400. The two balances are added after removal of the 17,000 ending unrealized gross profit see requirement [c]. Investment in Rose Company ⫽ –0–. The investment balance is eliminated so that the actual assets and liabilities of the subsidiary can be included. Land ⫽ 706,000. The two balances are added. The 28,000 unrealized gain created by the transfer is removed. Equipment ⫽ 480,000. The two balances are added. Because of the intra-entity transfer, 20,000 must also be included to adjust the 80,000 transfer price to the original 100,000 cost of the asset. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 224 Chapter 5 Accumulated Depreciation ⫽ 278,800. The balances are combined and adjusted for 52,400 to reinstate the historical balance for the equipment transferred across affiliates 56,000 written off at date of transfer less 3,600 for the previous year’s depreciation on the intra-entity gain. Then, an additional 3,600 is removed for the current year’s depreciation on the intra- entity gain. Trademark ⫽ 52,500. The amount from the original 75,000 acquisition-date excess fair-value allocation less 3 years’ amortization at 7,500 per year. Goodwill ⫽ 57,500. The amount from the original allocation of the Rose’s acquisition-date fair value. Total Assets ⫽ 2,328,600. This figure is a summation of the preceding consolidated assets. Liabilities ⫽ 785,000. The two balances are added after removal of the 50,000 intra-entity payable created by the transfer of land. Noncontrolling Interest in Subsidiary, 123111 ⫽ 198,600. This figure is composed of several different balances: Rose 20 book value at 1111 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164,000 20 of 1111 unamortized excess fair-value allocation for Rose’s net identifiable assets and goodwill 117,500 ⫻ 20. . . . 23,500 Noncontrolling interest at 1111 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187,500 2011 Rose income allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,100 Noncontrolling interest share of Rose dividends . . . . . . . . . . . . . . . . . . . . . 10,000 December 31, 2011, balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198,600 Common Stock ⫽ 600,000. Only the parent company balance is reported within the consolidated statements. Retained Earnings, 123111 ⫽ 745,000. The retained earnings amount is found by adding consolidated net income to the beginning Retained Earnings balance and then subtracting the dividends paid. All of these figures have been computed previously. Total Liabilities and Equities ⫽ 2,328,600. This figure is the summation of all consolidated liabilities and equities. g. Consolidation Worksheet Entries Intra-Entity Transactions December 31, 2011 Inventory Entry G Retained Earnings, 1111—Subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 To remove 2010 unrealized gross profit from beginning balances of the current year. Because transfers were upstream, retained earnings of the subsidiary as the original seller are being reduced. Balance is computed in requirement c. Entry TI Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000 Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000 To eliminate current year intra-entity transfer of inventory. Entry G Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000 To remove 2011 unrealized gross profit from ending accounts of the current year. Balance is computed in requirement c. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 225 Land Entry TL Gain on Sale of Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000 To eliminate gross profit created on first day of current year by an intra-entity transfer of land. Equipment Entry TA Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Investment in Rose Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,400 Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,400 To remove unrealized gross profit as of January 1, 2011 created by intra-entity transfer of equipment and to adjust equipment and accumulated depreciation to historical cost figures. Equipment is increased from the 80,000 transfer price to 100,000 cost. Accumulated depreciation of 56,000 was eliminated at time of transfer. Excess depreciation of 3,600 per year has been recorded for the prior year 3,600; thus, the accumulated depreciation is now only 52,400 less than the cost-based figure. The unrealized gain on the transfer was 36,000 80,000 less 44,000. That figure has now been reduced by one year of excess depreciation 3,600. Because the parent used the equity method and this transfer was downstream, the adjustment here is to the investment account rather than the parent’s beginning Retained Earnings. Entry ED Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 Operating Expenses depreciation . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 To eliminate the current year overstatement of depreciation created by inflated transfer price. Questions 1. Intra-entity transfers between the component companies of a business combination are quite common. Why do these intra-entity transactions occur so frequently? 2. Barker Company owns 80 percent of the outstanding voting stock of Walden Company. During the current year, intra-entity sales amount to 100,000. These transactions were made with a gross profit rate of 40 percent of the transfer price. In consolidating the two companies, what amount of these sales would be eliminated? 3. Padlock Corp. owns 90 percent of Safeco, Inc. During the year, Padlock sold 3,000 locking mechanisms to Safeco for 900,000. By the end of the year, Safeco had sold all but 500 of the locking mechanisms to outside parties. Padlock marks up the cost of its locking mechanisms by 60 percent in computing its sales price to affiliated and nonaffiliated customers. How much intra-entity profit remains in Safeco’s inventory at year-end? 4. How are unrealized inventory gross profits created, and what consolidation entries does the presence of these gains necessitate? 5. James, Inc., sells inventory to Matthews Company, a related party, at James’s standard markup. At the current fiscal year-end, Matthews still holds some portion of this inventory. If consolidated financial statements are prepared, why are worksheet entries required in two different fiscal periods? 6. How do intra-entity profits present in any year affect the noncontrolling interest calculations? 7. A worksheet is being developed to consolidate Williams, Incorporated, and Brown Company. These two organizations have made considerable intra-entity transactions. How would the consolidation To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 226 Chapter 5 process be affected if these transfers were downstream? How would the consolidation process be affected if these transfers were upstream? 8. King Company owns a 90 percent interest in the outstanding voting shares of Pawn Company. No excess fair-value amortization resulted from the acquisition. Pawn reports a net income of 110,000 for the current year. Intra-entity sales occur at regular intervals between the two companies. Unreal- ized gross profits of 30,000 were present in the beginning inventory balances, whereas 60,000 in similar gross profits were recorded at year-end. What is the noncontrolling interest’s share of the subsidiary’s net income? 9. When a subsidiary sells inventory to a parent, the intra-entity profit is removed from the subsidiary’s income and reduces the income allocation to the noncontrolling interest. Is the profit permanently eliminated from the noncontrolling interest, or is it merely shifted from one period to the next? Explain. 10. The consolidation process applicable when intra-entity land transfers have occurred differs somewhat from that used for intra-entity inventory sales. What differences should be noted? 11. A subsidiary sells land to the parent company at a significant gain. The parent holds the land for two years and then sells it to an outside party, also for a gain. How does the business combination account for these events? 12. Why does an intra-entity sale of a depreciable asset such as equipment or a building require subsequent adjustments to depreciation expense within the consolidation process? 13. If a seller makes an intra-entity sale of a depreciable asset at a price above book value, the seller’s beginning Retained Earnings is reduced when preparing each subsequent consolidation. Why does the amount of the adjustment change from year to year? Problems 1. What is the primary reason we defer financial statement recognition of gross profits on intra-entity sales for goods that remain within the consolidated entity at year end? a. Revenues and COGS must be recognized for all intra-entity sales regardless of whether the sales are upstream or downstream. b. Intra-entity sales result in gross profit overstatements regardless of amounts remaining in ending inventory. c. Gross profits must be deferred indefinitely because sales among affiliates always remain in the consolidated group. d. When intra-entity sales remain in ending inventory, ownership of the goods has not changed. 2. King Corporation owns 80 percent of Lee Corporation’s common stock. During October, Lee sold merchandise to King for 100,000. At December 31, 50 percent of this merchandise remains in King’s inventory. Gross profit percentages were 30 percent for King and 40 percent for Lee. The amount of unrealized intra-entity profit in ending inventory at December 31 that should be eliminated in the consolidation process is a. 40,000. b. 20,000. c. 16,000. d. 15,000. AICPA adapted 3. In computing the noncontrolling interest’s share of consolidated net income, how should the subsidiary’s income be adjusted for intra-entity transfers? a. The subsidiary’s reported income is adjusted for the impact of upstream transfers prior to computing the noncontrolling interest’s allocation. b. The subsidiary’s reported income is adjusted for the impact of all transfers prior to computing the noncontrolling interest’s allocation. c. The subsidiary’s reported income is not adjusted for the impact of transfers prior to computing the noncontrolling interest’s allocation. d. The subsidiary’s reported income is adjusted for the impact of downstream transfers prior to computing the noncontrolling interest’s allocation. 4. Bellgrade, Inc., acquired a 60 percent interest in Hansen Company several years ago. During 2011, Hansen sold inventory costing 75,000 to Bellgrade for 100,000. A total of 16 percent of this inventory was not sold to outsiders until 2012. During 2012, Hansen sold inventory costing 96,000 LO1 LO3 LO5 LO2, LO3 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 227 to Bellgrade for 120,000. A total of 35 percent of this inventory was not sold to outsiders until 2013. In 2012, Bellgrade reported cost of goods sold of 380,000 while Hansen reported 210,000. What is the consolidated cost of goods sold in 2012? a. 465,600. b. 473,440. c. 474,400. d. 522,400. 5. Top Company holds 90 percent of Bottom Company’s common stock. In the current year, Top reports sales of 800,000 and cost of goods sold of 600,000. For this same period, Bottom has sales of 300,000 and cost of goods sold of 180,000. During the current year, Top sold merchandise to Bottom for 100,000. The subsidiary still possesses 40 percent of this inventory at the current year- end. Top had established the transfer price based on its normal markup. What are the consolidated sales and cost of goods sold? a. 1,000,000 and 690,000. b. 1,000,000 and 705,000. c. 1,000,000 and 740,000. d. 970,000 and 696,000. 6. Use the same information as in problem 5 except assume that the transfers were from Bottom Com- pany to Top Company. What are the consolidated sales and cost of goods sold? a. 1,000,000 and 720,000. b. 1,000,000 and 755,000. c. 1,000,000 and 696,000. d. 970,000 and 712,000. 7. Hardwood, Inc., holds a 90 percent interest in Pittstoni Company. During 2010, Pittstoni sold inventory costing 77,000 to Hardwood for 110,000. Of this inventory, 40,000 worth was not sold to outsiders until 2011. During 2011, Pittstoni sold inventory costing 72,000 to Hardwood for 120,000. A total of 50,000 of this inventory was not sold to outsiders until 2012. In 2011, Hard- wood reported net income of 150,000 while Pittstoni earned 90,000 after excess amortizations. What is the noncontrolling interest in the 2011 income of the subsidiary? a. 8,000. b. 8,200. c. 9,000. d. 9,800. 8. Dunn Corporation owns 100 percent of Grey Corporation’s common stock. On January 2, 2010, Dunn sold to Grey for 40,000 machinery with a carrying amount of 30,000. Grey is depreciating the acquired machinery over a five-year life by the straight-line method. The net adjustments to compute 2010 and 2011 consolidated net income would be an increase decrease of 2010 2011 a. 8,000 2,000 b. 8,000 –0– c. 10,000 2,000 d. 10,000 –0– AICPA adapted 9. Wallton Corporation owns 70 percent of the outstanding stock of Hastings, Incorporated. On Janu- ary 1, 2009, Wallton acquired a building with a 10-year life for 300,000. Wallton anticipated no salvage value, and the building was to be depreciated on the straight-line basis. On January 1, 2011, Wallton sold this building to Hastings for 280,000. At that time, the building had a remaining life of eight years but still no expected salvage value. In preparing financial statements for 2011, how does this transfer affect the computation of consolidated net income? a. Income must be reduced by 32,000. b. Income must be reduced by 35,000. c. Income must be reduced by 36,000. d. Income must be reduced by 40,000. LO2, LO3 LO3, LO5 LO7 LO2, LO3, LO5 LO7 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 228 Chapter 5 Use the following data for problems 10–15: On January 1, Jarel acquired 80 percent of the outstanding voting stock of Suarez for 260,000 cash consideration. The remaining 20 percent of Suarez had an acquisition-date fair value of 65,000. On January 1, Suarez possessed equipment 5-year life that was undervalued on its books by 25,000. Suarez also had developed several secret formulas that Jarel assessed at 50,000. These formulas, although not recorded on Suarez’s financial records, were estimated to have a 20-year future life. As of December 31, the financial statements appeared as follows: Jarel Suarez Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 200,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 80,000 Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 10,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 110,000 Retained earnings, 11 . . . . . . . . . . . . . . . . . . . . . . . 300,000 150,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 110,000 Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– –0– Retained earnings, 1231 . . . . . . . . . . . . . . . . . . . 440,000 260,000 Cash and receivables . . . . . . . . . . . . . . . . . . . . . . . . 210,000 90,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 110,000 Investment in Suarez . . . . . . . . . . . . . . . . . . . . . . . . 260,000 –0– Equipment net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440,000 300,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,060,000 500,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000 140,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 100,000 Retained earnings, 1231 . . . . . . . . . . . . . . . . . . . . . 440,000 260,000 Total liabilities and equities . . . . . . . . . . . . . . . . . . 1,060,000 500,000 During the year, Jarel bought inventory for 80,000 and sold it to Suarez for 100,000. Of these goods, Suarez still owns 60 percent on December 31. 10. What is the total of consolidated revenues? a. 500,000. b. 460,000. c. 420,000. d. 400,000. 11. What is the total of consolidated cost of goods sold? a. 140,000. b. 152,000. c. 132,000. d. 145,000. 12. What is the total of consolidated expenses? a. 30,000. b. 36,000. c. 37,500. d. 39,000. 13. What is the consolidated total of noncontrolling interest appearing on the balance sheet? a. 85,500. b. 83,100. c. 87,000. d. 70,500. 14. What is the consolidated total for equipment net at December 31? a. 740,000. b. 756,000. c. 760,000. d. 765,000. LO2 LO2, LO3 LO1 LO5 LO7 Chapter 3 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 229 15. What is the consolidated total for inventory at December 31? a. 240,000. b. 248,000. c. 250,000. d. 260,000. 16. Following are several figures reported for Preston and Sanchez as of December 31, 2011: Preston Sanchez Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 200,000 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 600,000 Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . not given Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 300,000 Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 180,000 250,000 Preston acquired 70 percent of Sanchez in January 2010. In allocating the newly acquired subsidiary’s fair value at the acquisition date, Preston noted that Sanchez having developed a customer list worth 65,000 unrecorded on its accounting records and having a five-year remaining life. Any remaining excess fair value over Sanchez’s book value was attributed to goodwill. During 2011, Sanchez sells inventory costing 120,000 to Preston for 160,000. Of this amount, 20 percent remains unsold in Preston’s warehouse at year-end. For Preston’s consolidated reports, determine the following amounts to be reported for the current year. Inventory Sales Cost of Goods Sold Operating Expenses Noncontrolling Interest in the Subsidiary’s Net Income 17. On January 1, 2010, Corgan Company acquired 80 percent of the outstanding voting stock of Smash- ing, Inc., for a total of 980,000 in cash and other consideration. At the acquisition date, Smashing had common stock of 700,000, retained earnings of 250,000, and a noncontrolling interest fair value of 245,000. Corgan attributed the excess of fair value over Smashing’s book value to various covenants with a 20-year life. Corgan uses the equity method to account for its investment in Smashing. During the next two years, Smashing reported the following: Net Income Dividends Inventory Purchases from Corgan 2010 150,000 35,000 100,000 2011 130,000 45,000 120,000 Corgan sells inventory to Smashing using a 60 percent markup on cost. At the end of 2010 and 2011, 40 percent of the current year purchases remain in Smashing’s inventory. a. Compute the equity method balance in Corgan’s Investment in Smashing, Inc., account as of December 31, 2011. b. Prepare the worksheet adjustments for the December 31, 2011, consolidation of Corgan and Smashing. 18. Smith Corporation acquired 80 percent of the outstanding voting stock of Kane, Inc., on January 1, 2010, when Kane had a net book value of 400,000. Any excess fair value was assigned to intangible assets and amortized at a rate of 5,000 per year. Reported net income for 2011 was 300,000 for Smith and 110,000 for Kane. Smith distributed 100,000 in dividends during this period; Kane paid 40,000. At year-end, selected figures from the two companies’ balance sheets were as follows: Smith Corporation Kane, Inc. Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 90,000 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 200,000 Equipment net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 300,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 200,000 Retained earnings, 123111 . . . . . . . . . . . . . . . . . . . 600,000 400,000 LO3 LO2, LO3, LO5 LO3, LO4, LO5 LO1, LO3, LO4, LO5, LO6, LO7 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 230 Chapter 5 During 2010, intra-entity sales of 90,000 original cost of 54,000 were made. Only 20 percent of this inventory was still held at the end of 2010. In 2011, 120,000 in intra-entity sales were made with an original cost of 66,000. Of this merchandise, 30 percent had not been resold to outside parties by the end of the year. Each of the following questions should be considered as an independent situation. a. If the intra-entity sales were upstream, what is the noncontrolling interest’s share of the subsidiary’s 2011 net income? b. What is the consolidated balance in the ending Inventory account? c. If the intra-entity sales were downstream, what is the noncontrolling interest’s share of the subsidiary’s 2011 net income? d. If the intra-entity sales were downstream, what is the consolidated net income? Assume that Smith uses the initial value method to account for this investment. e. If the intra-entity sales were downstream, what is the consolidated balance of the Retained Earn- ings account as of the end of 2011? Assume that Smith uses the partial equity method to account for this investment. f. If the intra-entity sales were upstream, what is the consolidated balance for Retained Earnings as of the end of 2011? Assume that Smith uses the partial equity method to account for this investment. g. Assume that no intra-entity inventory sales occurred between Smith and Kane. Instead, in 2010, Kane sold land costing 30,000 to Smith for 50,000. On the 2011 consolidated balance sheet, what value should be reported for land? h. Assume that no intra-entity inventory or land sales occurred between Smith and Kane. Instead, on January 1, 2010, Kane sold equipment that originally cost 100,000 but had a 60,000 book value on that date to Smith for 80,000. At the time of sale, the equipment had a remaining use- ful life of five years. What worksheet entries are made for a December 31, 2011, consolidation of these two companies to eliminate the impact of the intra-entity transfer? For 2011, what is the noncontrolling interest’s share of Kane’s net income? 19. On January 1, 2010, Doone Corporation acquired 60 percent of the outstanding voting stock of Rockne Company for 300,000 consideration. At the acquisition date, the fair value of the 40 percent noncontrolling interest was 200,000 and Rockne’s assets and liabilities had a collective net fair value of 500,000. Doone uses the equity method in its internal records to account for its investment in Rockne. Rockne reports net income of 160,000 in 2011. Since being acquired, Rockne has regularly supplied inventory to Doone at 25 percent more than cost. Sales to Doone amounted to 250,000 in 2010 and 300,000 in 2011. Approximately 30 percent of the inventory purchased during any one year is not used until the following year. a. What is the noncontrolling interest’s share of Rockne’s 2011 income? b. Prepare Doone’s 2011 consolidation entries required by the intra-entity inventory transfers. 20. Penguin Corporation acquired 80 percent of the outstanding voting stock of Snow Company on January 1, 2010, for 420,000 in cash and other consideration. At the acquisition date, Penguin assessed Snow’s identifiable assets and liabilities at a collective net fair value of 525,000 and the fair value of the 20 percent noncontrolling interest was 105,000. No excess fair value over book value amortization accompanied the acquisition. The following selected account balances are from the individual financial records of these two companies as of December 31, 2011: Penguin Snow Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640,000 360,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 290,000 197,000 Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 105,000 Retained earnings, 1111 . . . . . . . . . . . . . . . . . . . . . 740,000 180,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346,000 110,000 Buildings net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 358,000 157,000 Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . Not given –0– Each of the following problems is an independent situation: a. Assume that Penguin sells Snow inventory at a markup equal to 40 percent of cost. Intra-entity transfers were 90,000 in 2010 and 110,000 in 2011. Of this inventory, Snow retained and then sold 28,000 of the 2010 transfers in 2011 and held 42,000 of the 2011 transfers until 2012. LO2, LO3, LO4, LO5 LO3, LO4, LO5, LO7 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 231 On consolidated financial statements for 2011, determine the balances that would appear for the following accounts: Cost of Goods Sold Inventory Noncontrolling Interest in Subsidiary’s Net Income b. Assume that Snow sells inventory to Penguin at a markup equal to 40 percent of cost. Intra-entity transfers were 50,000 in 2010 and 80,000 in 2011. Of this inventory, 21,000 of the 2010 transfers were retained and then sold by Penguin in 2011, whereas 35,000 of the 2011 transfers were held until 2012. On consolidated financial statements for 2011, determine the balances that would appear for the following accounts: Cost of Goods Sold Inventory Noncontrolling Interest in Subsidiary’s Net Income c. Penguin sells Snow a building on January 1, 2010, for 80,000, although its book value was only 50,000 on this date. The building had a five-year remaining life and was to be depreciated using the straight-line method with no salvage value. Determine the balances that would appear on consolidated financial statements for 2011 for Buildings net Operating Expenses Noncontrolling Interest in Subsidiary’s Net Income 21. Akron, Inc., owns all outstanding stock of Toledo Corporation. Amortization expense of 15,000 per year for patented technology resulted from the original acquisition. For 2011, the companies had the following account balances: Akron Toledo Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100,000 600,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 400,000 Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 220,000 Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . Not given –0– Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 30,000 Intra-entity sales of 320,000 occurred during 2010 and again in 2011. This merchandise cost 240,000 each year. Of the total transfers, 70,000 was still held on December 31, 2010, with 50,000 unsold on December 31, 2011. a. For consolidation purposes, does the direction of the transfers upstream or downstream affect the balances to be reported here? b. Prepare a consolidated income statement for the year ending December 31, 2011. 22. On January 1, 2010, QuickPort Company acquired 90 percent of the outstanding voting stock of NetSpeed, Inc., for 810,000 in cash and stock options. At the acquisition date, NetSpeed had Com- mon Stock of 800,000 and Retained Earnings of 40,000. The acquisition-date fair value of the 10 percent noncontrolling interest was 90,000. QuickPort attributed the 60,000 excess of NetSpeed’s fair value over book value to a database with a 5-year remaining life. During the next two years, NetSpeed reported the following: Income Dividends 2010 80,000 8,000 2011 115,000 8,000 On July 1, 2010, QuickPort sold communication equipment to NetSpeed for 42,000. The equipment originally cost 48,000 and had accumulated depreciation of 9,000 and an estimated remaining life of three years at the date of the intra-entity transfer. a. Compute the equity method balance in QuickPort’s Investment in NetSpeed, Inc., account as of December 31, 2011. b. Prepare the worksheet adjustments for the December 31, 2011, consolidation of QuickPort and NetSpeed. LO3, LO4, LO5 LO7 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 232 Chapter 5 23. Padre holds 100 percent of the outstanding shares of Sonora. On January 1, 2009, Padre transferred equipment to Sonora for 95,000. The equipment had cost 130,000 originally but had a 50,000 book value and five-year remaining life at the date of transfer. Depreciation expense is computed according to the straight-line method with no salvage value. Consolidated financial statements for 2011 currently are being prepared. What worksheet entries are needed in connection with the consolidation of this asset? Assume that the parent applies the partial equity method. 24. On January 1, 2011, Slaughter sold equipment to Bennett a wholly owned subsidiary for 120,000 in cash. The equipment had originally cost 100,000 but had a book value of only 70,000 when transferred. On that date, the equipment had a five-year remaining life. Depreciation expense is computed using the straight-line method. Slaughter earned 220,000 in net income in 2011 not including any investment income while Bennett reported 90,000. Slaughter attributed any excess acquisition-date fair value to Bennett’s unpatented technology, which was amortized at a rate of 8,000 per year. a. What is the consolidated net income for 2011? b. What is the parent’s share of consolidated net income for 2011 if Slaughter owns only 90 percent of Bennett? c. What is the parent’s share of consolidated net income for 2011 if Slaughter owns only 90 percent of Bennett and the equipment transfer was upstream? d. What is the consolidated net income for 2012 if Slaughter reports 240,000 does not include investment income and Bennett 100,000 in income? Assume that Bennett is a wholly owned subsidiary and the equipment transfer was downstream. 25. Anchovy acquired 90 percent of Yelton on January 1, 2009. Of Yelton’s total acquisition-date fair value, 60,000 was allocated to undervalued equipment with a 10-year life and 80,000 was attributed to franchises to be written off over a 20-year period. Since the takeover, Yelton has transferred inventory to its parent as follows: Year Cost Transfer Price Remaining at Year-End 2009 20,000 50,000 20,000 at transfer price 2010 49,000 70,000 30,000 at transfer price 2011 50,000 100,000 40,000 at transfer price On January 1, 2010, Anchovy sold Yelton a building for 50,000 that had originally cost 70,000 but had only a 30,000 book value at the date of transfer. The building is estimated to have a five- year remaining life straight-line depreciation is used with no salvage value. Selected figures from the December 31, 2011, trial balances of these two companies are as follows: Anchovy Yelton Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 500,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 260,000 Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 80,000 Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . Not given –0– Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 80,000 Equipment net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 110,000 Buildings net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000 190,000 Determine consolidated totals for each of these account balances. 26. On January 1, 2011, Sledge had common stock of 120,000 and retained earnings of 260,000. Dur- ing that year, Sledge reported sales of 130,000, cost of goods sold of 70,000, and operating expenses of 40,000. On January 1, 2009, Percy, Inc., acquired 80 percent of Sledge’s outstanding voting stock. At that date, 60,000 of the acquisition-date fair value was assigned to unrecorded contracts with a 20-year life and 20,000 to an undervalued building with a 10-year life. In 2010, Sledge sold inventory costing 9,000 to Percy for 15,000. Of this merchandise, Percy continued to hold 5,000 at year-end. During 2011, Sledge transferred inventory costing 11,000 to Percy for 20,000. Percy still held half of these items at year-end. On January 1, 2010, Percy sold equipment to Sledge for 12,000. This asset originally cost 16,000 but had a January 1, 2010, book value of 9,000. At the time of transfer, the equipment’s remaining life was estimated to be five years. LO7 LO7 LO2, LO3, LO4, LO7 LO3, LO4, LO5, LO7 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 233 Percy has properly applied the equity method to the investment in Sledge. a. Prepare worksheet entries to consolidate these two companies as of December 31, 2011. b. Compute the noncontrolling interest in the subsidiary’s income for 2011. 27. Pitino acquired 90 percent of Brey’s outstanding shares on January 1, 2009, in exchange for 342,000 in cash. The subsidiary’s stockholders’ equity accounts totaled 326,000 and the noncontrolling interest had a fair value of 38,000 on that day. However, a building with a nine-year remaining life in Brey’s accounting records was undervalued by 18,000. Pitino assigned the rest of the excess fair value over book value to Brey’s patented technology six-year remaining life. Brey reported net income from its own operations of 64,000 in 2009 and 80,000 in 2010. Brey paid dividends of 19,000 in 2009 and 23,000 in 2010. Brey sells inventory to Pitino as follows: Inventory Remaining Transfer Price at Year-End Year Cost to Brey to Pitino at transfer price 2009 69,000 115,000 25,000 2010 81,000 135,000 37,500 2011 92,800 160,000 50,000 At December 31, 2011, Pitino owes Brey 16,000 for inventory acquired during the period. The following separate account balances are for these two companies for December 31, 2011, and the year then ended. Credits are indicated by parentheses. Pitino Brey Sales revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 862,000 366,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 515,000 209,000 Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185,400 67,000 Investment income—Brey . . . . . . . . . . . . . . . . . . . . . 68,400 –0– Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,000 90,000 Retained earnings, 1111 . . . . . . . . . . . . . . . . . . . . . 488,000 278,000 Net income above . . . . . . . . . . . . . . . . . . . . . . . . . 230,000 90,000 Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,000 27,000 Retained earnings, 123111 . . . . . . . . . . . . . . . . . 582,000 341,000 Cash and receivables . . . . . . . . . . . . . . . . . . . . . . . . 146,000 98,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255,000 136,000 Investment in Brey . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000 –0– Land, buildings, and equipment net . . . . . . . . . . . . 964,000 328,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,815,000 562,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718,000 71,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515,000 150,000 Retained earnings, 123111 . . . . . . . . . . . . . . . . . . . 582,000 341,000 Total liabilities and equities . . . . . . . . . . . . . . . . . . 1,815,000 562,000 Answer each of the following questions: a. What was the annual amortization resulting from the acquisition-date fair-value allocations? b. Were the intra-entity transfers upstream or downstream? c. What unrealized gross profit existed as of January 1, 2011? d. What unrealized gross profit existed as of December 31, 2011? e. What amounts make up the 68,400 Investment Income—Brey account balance for 2011? f. What was the noncontrolling interest’s share of the subsidiary’s net income for 2011? g. What amounts make up the 450,000 Investment in Brey account balance as of December 31, 2011? h. Prepare the 2011 worksheet entry to eliminate the subsidiary’s beginning owners’ equity balances. i. Without preparing a worksheet or consolidation entries, determine the consolidation balances for these two companies. LO1, LO2, LO3, LO5 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 234 Chapter 5 28. Bennett acquired 70 percent of Zeigler on June 30, 2010, for 910,000 in cash. Based on Zeigler’s acquisition-date fair value, an unrecorded intangible of 400,000 was recognized and is being amortized at the rate of 10,000 per year. The noncontrolling interest fair value was assessed at 390,000 at the acquisition date. The 2011 financial statements are as follows: Bennett Zeigler Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 600,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000 400,000 Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000 Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 –0– Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 100,000 Retained earnings, 1111 . . . . . . . . . . . . . . . . . . . . . 1,300,000 850,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 100,000 Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 50,000 Retained earnings, 123111 . . . . . . . . . . . . . . . . . 1,400,000 900,000 Cash and receivables . . . . . . . . . . . . . . . . . . . . . . . . 400,000 300,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290,000 700,000 Investment in Zeigler . . . . . . . . . . . . . . . . . . . . . . . . 910,000 –0– Fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 600,000 Accumulated depreciation . . . . . . . . . . . . . . . . . . . . 300,000 200,000 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300,000 1,400,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 400,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 100,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400,000 900,000 Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,300,000 1,400,000 Bennett sold Zeigler inventory costing 72,000 during the last six months of 2010 for 120,000. At year-end, 30 percent remained. Bennett sells Zeigler inventory costing 200,000 during 2011 for 250,000. At year-end, 20 percent is left. With these facts, determine the consolidated balances for the accounts: Sales Cost of Goods Sold Operating Expenses Dividend Income Noncontrolling Interest in Consolidated Income Inventory Noncontrolling Interest in Subsidiary, 123111 29. Compute the balances in problem 28 again, assuming that all intra-entity transfers were made from Zeigler to Bennett. 30. Following are financial statements for Moore Company and Kirby Company for 2011: Moore Kirby Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 600,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 400,000 Operating and interest expenses . . . . . . . . . . . . . . . . 100,000 160,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 40,000 Retained earnings, 1111 . . . . . . . . . . . . . . . . . . . . . 990,000 550,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 40,000 Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000 –0– Retained earnings, 123111 . . . . . . . . . . . . . . . . . 1,060,000 590,000 Cash and receivables . . . . . . . . . . . . . . . . . . . . . . . . 217,000 180,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224,000 160,000 Investment in Kirby . . . . . . . . . . . . . . . . . . . . . . . . . . 657,000 –0– LO2, LO3, LO5 LO2, LO3, LO4, LO5 continued LO1, LO2, LO3, LO4, LO5, LO7 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 235 Moore Kirby Equipment net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 420,000 Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 650,000 Accumulated depreciation—buildings . . . . . . . . . . . . 100,000 200,000 Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 100,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,798,000 1,310,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,138,000 570,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 150,000 Retained earnings, 123111 . . . . . . . . . . . . . . . . . . . 1,060,000 590,000 Total liabilities and equity . . . . . . . . . . . . . . . . . . . 2,798,000 1,310,000 • Moore purchased 90 percent of Kirby on January 1, 2010, for 657,000 in cash. On that date, the 10 percent noncontrolling interest was assessed to have a 73,000 fair value. Also at the acquisition date, Kirby held equipment 4-year remaining life undervalued on the financial records by 20,000 and interest-bearing liabilities 5-year remaining life overvalued by 40,000. The rest of the excess fair value over book value was assigned to previously unrecog- nized brand names and amortized over a 10-year life. • During 2010 Kirby earned a net income of 80,000 and paid no dividends. • Each year Kirby sells Moore inventory at a 20 percent gross profit rate. Intra-entity sales were 145,000 in 2010 and 160,000 in 2011. On January 1, 2011, 30 percent of the 2010 transfers were still on hand and, on December 31, 2011, 40 percent of the 2011 transfers remained. • Moore sold Kirby a building on January 2, 2010. It had cost Moore 100,000 but had 90,000 in accumulated depreciation at the time of this transfer. The price was 25,000 in cash. At that time, the building had a five-year remaining life. Determine all consolidated balances either computationally or by using a worksheet. 31. On January 1, 2010, Woods, Inc., acquired a 60 percent interest in the common stock of Scott, Inc., for 672,000. Scott’s book value on that date consisted of common stock of 100,000 and retained earnings of 220,000. Also, the Junuary 1, 2010, fair value on the 40 percent noncontrolling interest was 248,000. The subsidiary held patents with a 10-year remaining life that were undervalued within the company’s accounting records by 70,000 and an unrecorded customer list 15-year remaining life assessed at a 45,000 fair value. Any remaining excess acquisition-date fair value was assigned to goodwill. Since acquisition, Woods has applied the equity method to its Investment in Scott account and no goodwill impairment has occurred. Intra-entity inventory sales between the two companies have been made as follows: Transfer Price Ending Balance Year Cost to Woods to Scott at transfer price 2010 120,000 150,000 50,000 2011 112,000 160,000 40,000 The individual financial statements for these two companies as of December 31, 2011, and the year then ended follow: Woods, Inc. Scott, Inc. Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000 335,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 460,000 205,000 Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 188,000 70,000 Equity earnings in Scott . . . . . . . . . . . . . . . . . . . . . . 28,000 –0– Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 60,000 Retained earnings, 1111 . . . . . . . . . . . . . . . . . . . . . 695,000 280,000 Net income above . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 60,000 Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000 15,000 Retained earnings, 123111 . . . . . . . . . . . . . . . . . 730,000 325,000 LO2, LO3, LO4, LO5 continued To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 236 Chapter 5 Woods, Inc. Scott, Inc. Cash and receivables . . . . . . . . . . . . . . . . . . . . . . . . 248,000 148,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233,000 129,000 Investment in Scott . . . . . . . . . . . . . . . . . . . . . . . . . . 411,000 –0– Buildings net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308,000 202,000 Equipment net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 86,000 Patents net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 20,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,420,000 585,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390,000 160,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 100,000 Retained earnings, 123111 . . . . . . . . . . . . . . . . . . . 730,000 325,000 Total liabilities and equities . . . . . . . . . . . . . . . . . . 1,420,000 585,000 a. Show how Woods determined the 411,000 Investment in Scott account balance. Assume that Woods defers 100 percent of downstream intra-entity profits against its share of Scott’s income. b. Prepare a consolidated worksheet to determine appropriate balances for external financial reporting as of December 31, 2011. 32. On January 1, 2009, Plymouth Corporation acquired 80 percent of the outstanding voting stock of Sander Company in exchange for 1,200,000 cash. At that time, although Sander’s book value was 925,000, Plymouth assessed Sander’s total business fair value at 1,500,000. Since that time, Sander has neither issued nor reacquired any shares of its own stock. The book values of Sander’s individual assets and liabilities approximated their acquisition-date fair values except for the patent account, which was undervalued by 350,000. The undervalued patents had a 5-year remaining life at the acquisition date. Any remaining excess fair value was attributed to goodwill. No goodwill impairments have occurred. Sander regularly sells inventory to Plymouth. Below are details of the intra-entity inventory sales for the past three years: Intra-Entity Gross Profit Rate Intra-Entity Ending Inventory on Intra-Entity Year Sales at Transfer Price Inventory Transfers 2009 125,000 80,000 25 2010 220,000 125,000 28 2011 300,000 160,000 25 Separate financial statements for these two companies as of December 31, 2011, follow: Plymouth Sander Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,740,000 950,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 820,000 500,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . 104,000 85,000 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . 220,000 120,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 15,000 Equity in earnings of Sander . . . . . . . . . . . . . . . . . . . 124,000 –0– Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000 230,000 Retained earnings 1111 . . . . . . . . . . . . . . . . . . . . . 2,800,000 345,000 Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000 230,000 Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 25,000 Retained earnings 123111 . . . . . . . . . . . . . . . . . 3,300,000 550,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000 115,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 575,000 215,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 990,000 800,000 Investment in Sander . . . . . . . . . . . . . . . . . . . . . . . . 1,420,000 –0– Buildings and equipment . . . . . . . . . . . . . . . . . . . . . 1,025,000 863,000 Patents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000 107,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,495,000 2,100,000 LO2, LO3, LO4, LO5 continued To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 237 Plymouth Sander Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000 200,000 Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 545,000 450,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000 800,000 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . 300,000 100,000 Retained earnings 123111 . . . . . . . . . . . . . . . . . . . 3,300,000 550,000 Total liabilities and stockholders’ equity . . . . . . . . . 5,495,000 2,100,000 a. Prepare a schedule that calculates the Equity in Earnings of Sander account balance. b. Prepare a worksheet to arrive at consolidated figures for external reporting purposes. 33. On January 1, 2009, Monica Company acquired 70 percent of Young Company’s outstanding common stock for 665,000. The fair value of the noncontrolling interest at the acquisition date was 285,000. Young reported stockholders’ equity accounts on that date as follows: Common stock—10 par value . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410,000 In establishing the acquisition value, Monica appraised Young’s assets and ascertained that the accounting records undervalued a building with a five-year life by 50,000. Any remaining excess acquisition-date fair value was allocated to a franchise agreement to be amortized over 10 years. During the subsequent years, Young sold Monica inventory at a 30 percent gross profit rate. Monica consistently resold this merchandise in the year of acquisition or in the period immediately following. Transfers for the three years after this business combination was created amounted to the following: Inventory Remaining at Year-End Year Transfer Price at transfer price 2009 60,000 10,000 2010 80,000 12,000 2011 90,000 18,000 In addition, Monica sold Young several pieces of fully depreciated equipment on January 1, 2010, for 36,000. The equipment had originally cost Monica 50,000. Young plans to depreciate these assets over a six-year period. In 2011, Young earns a net income of 160,000 and distributes 50,000 in cash dividends. These figures increase the subsidiary’s Retained Earnings to a 740,000 balance at the end of 2011. Dur- ing this same year, Monica reported dividend income of 35,000 and an investment account containing the initial value balance of 665,000. Prepare the 2011 consolidation worksheet entries for Monica and Young. In addition, compute the noncontrolling interest’s share of the subsidiary’s net income for 2011. 34. Assume the same basic information as presented in problem 33 except that Monica employs the equity method of accounting. Hence, it reports 102,740 investment income for 2011 with an Investment account balance of 826,220. Under these circumstances, prepare the worksheet entries required for the consolidation of Monica Company and Young Company. 35. The individual financial statements for Gibson Company and Keller Company for the year ending December 31, 2011, follow. Gibson acquired a 60 percent interest in Keller on January 1, 2010, in exchange for various considerations totaling 570,000. At the acquisition date, the fair value of the noncontrolling interest was 380,000 and Keller’s book value was 850,000. Keller had developed internally a customer list that was not recorded on its books but had an acquisition-date fair value of 100,000. This intangible asset is being amortized over 20 years. Gibson sold Keller land with a book value of 60,000 on January 2, 2010, for 100,000. Keller still holds this land at the end of the current year. Keller regularly transfers inventory to Gibson. In 2010, it shipped inventory costing 100,000 to Gibson at a price of 150,000. During 2011, intra-entity shipments totaled 200,000, although the original cost to Keller was only 140,000. In each of these years, 20 percent of the merchandise was LO2, LO3, LO4, LO5, LO7 LO2, LO3, LO4, LO5, LO7 LO2, LO3, LO4, LO5, LO6 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 238 Chapter 5 not resold to outside parties until the period following the transfer. Gibson owes Keller 40,000 at the end of 2011. Gibson Keller Company Company Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 500,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 300,000 Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 60,000 Income of Keller Company . . . . . . . . . . . . . . . . . . . . 84,000 –0– Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284,000 140,000 Retained earnings, 1111 . . . . . . . . . . . . . . . . . . . . . 1,116,000 620,000 Net income above . . . . . . . . . . . . . . . . . . . . . . . . . 284,000 140,000 Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000 60,000 Retained earnings, 123111 . . . . . . . . . . . . . . . . . 1,285,000 700,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177,000 90,000 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . 356,000 410,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440,000 320,000 Investment in Keller Company . . . . . . . . . . . . . . . . . 726,000 –0– Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000 390,000 Buildings and equipment net . . . . . . . . . . . . . . . . . 496,000 300,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,375,000 1,510,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480,000 400,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 610,000 320,000 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . –0– 90,000 Retained earnings, 123111 . . . . . . . . . . . . . . . . . . . 1,285,000 700,000 Total liabilities and equities . . . . . . . . . . . . . . . . . . 2,375,000 1,510,000 a. Prepare a worksheet to consolidate the separate 2011 financial statements for Gibson and Keller. b. How would the consolidation entries in requirement a have differed if Gibson had sold a building with a 60,000 book value cost of 140,000 to Keller for 100,000 instead of land, as the problem reports? Assume that the building had a 10-year remaining life at the date of transfer. 36. On January 1, 2010, Parkway, Inc., issued securities with a total fair value of 450,000 for 100 percent of Skyline Corporation’s outstanding ownership shares. Skyline has long supplied inventory to Parkway, which hopes to achieve synergies with production scheduling and product development with this combination. Although Skyline’s book value at the acquisition date was 300,000, the fair value of its trademarks was assessed to be 30,000 more than their carrying values. Additionally, Skyline’s patented technology was undervalued in its accounting records by 120,000. The trademarks were considered to have indefinite lives, the estimated remaining life of the patented technology was eight years. In 2010, Skyline sold Parkway inventory costing 30,000 for 50,000. As of December 31, 2010, Parkway had resold only 28 percent of this inventory. In 2011, Parkway bought from Skyline 80,000 of inventory that had an original cost of 40,000. At the end of 2011, Parkway held 28,000 of inventory acquired from Skyline, all from its 2011 purchases. During 2011, Parkway sold Skyline a parcel of land for 95,000 and recorded a gain of 18,000 on the sale. Skyline still owes Parkway 65,000 related to the land sale. At the end of 2011, Parkway and Skyline prepared the following statements in preparation for consolidation. Parkway, Skyline Inc. Corporation Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627,000 358,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . 289,000 195,000 Other operating expenses . . . . . . . . . . . . . . . . . . . . . 170,000 75,000 Gain on sale of land . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 –0– Equity in Skyline’s earnings . . . . . . . . . . . . . . . . . . . . 55,400 –0– Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,400 88,000 LO2, LO3, LO4, LO6 continued To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Consolidated Financial Statements—Intra-Entity Asset Transactions 239 Parkway, Skyline Inc. Corporation Retained earnings 1111 . . . . . . . . . . . . . . . . . . . . . 314,600 292,000 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241,400 88,000 Dividends distributed . . . . . . . . . . . . . . . . . . . . . . . . 70,000 20,000 Retained earnings 123111 . . . . . . . . . . . . . . . . . 486,000 360,000 Cash and receivables . . . . . . . . . . . . . . . . . . . . . . . . 134,000 150,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281,000 112,000 Investment in Skyline . . . . . . . . . . . . . . . . . . . . . . . . 598,000 –0– Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 50,000 Land, buildings, and equip. net . . . . . . . . . . . . . . . 637,000 283,000 Patented technology . . . . . . . . . . . . . . . . . . . . . . . . –0– 130,000 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,650,000 725,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463,000 215,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410,000 120,000 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . 291,000 30,000 Retained earnings 123111 . . . . . . . . . . . . . . . . . . . 486,000 360,000 Total liabilities and equity . . . . . . . . . . . . . . . . . . . 1,650,000 725,000 a. Show how Parkway computed its 55,400 equity in Skyline’s earnings balance. b. Prepare a 2011 consolidated worksheet for Parkway and Skyline. Develop Your Skills EXCEL CASE On January 1, 2010, Patrick Company purchased 100 percent of the outstanding voting stock of Shawn, Inc., for 1,000,000 in cash and other consideration. At the purchase date, Shawn had common stock of 500,000 and retained earnings of 185,000. Patrick attributed the excess of acquisition-date fair value over Shawn’s book value to a trade name with a 25-year life. Patrick uses the equity method to account for its investment in Shawn. During the next two years, Shawn reported the following: Inventory Transfers to Income Dividends Patrick at Transfer Price 2010 78,000 25,000 190,000 2011 85,000 27,000 210,000 Shawn sells inventory to Patrick after a markup based on a gross profit rate. At the end of 2010 and 2011, 30 percent of the current year purchases remain in Patrick’s inventory. Required Create an Excel spreadsheet that computes the following: 1. Equity method balance in Patrick’s Investment in Shawn, Inc., account as of December 31, 2011. 2. Worksheet adjustments for the December 31, 2011, consolidation of Patrick and Shawn. Formulate your solution so that Shawn’s gross profit rate on sales to Patrick is treated as a variable. ANALYSIS AND RESEARCH CASE: ACCOUNTING INFORMATION AND SALARY NEGOTIATIONS Granger Eagles Players’ Association and Mr. Doublecount, the CEO of Granger Eagles Baseball Com- pany, ask your help in resolving a salary dispute. Mr. Doublecount presents the following income statement to the player representatives. CPA skills CPA skills To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 240 Chapter 5 GRANGER EAGLES BASEBALL COMPANY INCOME STATEMENT Ticket revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 Stadium rent expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400,000 Ticket expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000 Promotion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 Player salaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 Staff salaries and miscellaneous . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 2,060,000 Net income loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Mr. Doublecount argues that the Granger Eagles really lose money and, until things turn around, a salary increase is out of the question. As a result of your inquiry, you discover that Granger Eagles Baseball Company owns 91 percent of the voting stock in Eagle Stadium, Inc. This venue is specifically designed for baseball and is where the Eagles play their entire home game schedule. However, Mr. Doublecount does not wish to consider the profits of Eagle Stadium in the negotiations with the players. He claims that “the stadium is really a separate business entity that was purchased separately from the team” and therefore does not concern the players. The Eagles Stadium income statement appears as follows: EAGLES STADIUM, INC. INCOME STATEMENT Stadium rent revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400,000 Concession revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 Parking revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 2,300,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Staff salaries and miscellaneous . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 480,000 Net income loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,820,000 Required 1. What advice would you provide the negotiating parties regarding the issue of considering the Eagles Stadium income statement in their discussions? What authoritative literature could you cite in sup- porting your advice? 2. What other pertinent information would you need to provide a specific recommendation regarding players’ salaries? Please visit the text Web site for the online CPA Simulation Situation: Giant Company acquired all of Tiny Corporation’s outstanding common stock 4 years ago for 240,000 more than book value. This excess was assigned equally to a building 10-year life, inventory sold within 1 year, and goodwill. On its separate financial statements for the current year, Giant reported sales of 900,000, cost of goods sold of 500,000, and operating expenses of 200,000. No investment income was included in these figures. On its separate financial statements for the current year, Tiny reported sales of 500,000, cost of goods sold of 200,000, and operating expenses of 100,000. Both companies paid dividends of 20,000 this year. Both companies reported positive current ratios of above 1 to 1. Topics to be covered in simulation: • Intra-entity inventory transfers. • Intra-entity equipment transfer. • Intra-entity land transfer. • Intra-entity debts. • Equity method. • Push-down accounting. • Minority interest. • Negative goodwill. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com The consolidation of financial information can be a highly complex process often encompassing a number of practical challenges. This chapter examines the procedures required by several additional issues: • Variable interest entities. • Intra-entity debt. • Subsidiary preferred stock. • The consolidated statement of cash flows. • Computation of consolidated earnings per share. • Subsidiary stock transactions. Variable interest entities emerged over the past two decades as a new type of business structure that provided effective control of one firm by another without overt ownership. In response to the evolving nature of control relationships among firms, the FASB expanded its definition of control beyond the long-standing criterion of a majority voting interest to include control exercised through variable interests. This topic and some of the more traditional advanced business combination subjects listed above provide for further exploration of the complexities faced by the financial reporting community in providing relevant and reliable information to users of consolidated financial reports. CONSOLIDATION OF VARIABLE INTEREST ENTITIES Starting in the late 1970s, many firms began establishing separate business structures to help finance their operations at favorable rates. These structures became commonly known as special purpose entities SPEs, special purpose vehicles, or off-balance sheet structures. In this text, we refer to all such entities collectively as variable interest entities or VIEs. Many firms have routinely included their VIEs in their consolidated financial reports. However, others sought to avoid consolidation. 241 chapter 6 Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues LEARNING OBJECTIVES After studying this chapter, you should be able to: LO1 Describe a variable interest entity, a primary beneficiary, and the factors used to decide when a variable interest entity is subject to consolidation. LO2 Understand the consolidation procedures to eliminate all intra-entity debt accounts and recognize any associated gain or loss created whenever one company acquires an affiliate’s debt instrument from an outside party. LO3 Understand that subsidiary preferred stocks not owned by the parent are a component of the noncontrolling interest and are initially valued at acquisition-date fair value. LO4 Prepare a consolidated statement of cash flows. LO5 Compute basic and diluted earnings per share for a business combination. LO6 Understand the accounting for subsidiary stock transactions that impact the underlying value recorded within the parent’s Invest- ment account and the consolidated financial statements. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 242 Chapter 6 VIEs can help accomplish legitimate business purposes. Nonetheless, their use was widely criticized in the aftermath of Enron Corporation’s 2001 collapse. Because many firms avoided consolidation and used VIEs for off-balance sheet financing, such entities were often charac- terized as vehicles to hide debt and mislead investors. Other critics observed that firms with variable interests recorded questionable profits on sales to their VIEs that were not arm’s- length transactions. 1 The FASB ASC Variable Interest Entities sections within the Consolida- tions Topic were issued in response to such financial reporting abuses. Accounting standards for consolidating VIEs continue to evolve over time. In 2009, the FASB expanded consolidation requirements for entities previously known as qualifying special purpose entities QSPEs. Such QSPEs are often established to transform financial assets such as trade receivables, loans, or mortgages into securities that are offered in equity markets. Additionally in 2009 the FASB adopted a new qualitative assessment for deciding whether a firm must consolidate a VIE. Consolidation criteria now focus on the power to direct the activities of the entity as well as the obligation to absorb losses and the right to receive benefits from the VIE. What Is a VIE? A VIE can take the form of a trust, partnership, joint venture, or corporation although sometimes it has neither independent management nor employees. Most are established for valid business purposes, and transactions involving VIEs have become widespread. Common examples of VIE activities include transfers of financial assets, leasing, hedging financial instruments, research and development, and other transactions. An enterprise often sponsors a VIE to accomplish a well-defined and limited business activity and to provide low-cost financing. Low-cost financing of asset purchases is frequently a main benefit available through VIEs. Rather than engaging in the transaction directly, the business may sponsor a VIE to purchase and finance an asset acquisition. The VIE then leases the asset to the sponsor. This strategy saves the business money because the VIE is often eligible for a lower interest rate. This advantage is achieved for several reasons. First, the VIE typically operates with a very limited set of assets––in many cases just one asset. By isolating an asset in a VIE, the asset’s risk is isolated from the sponsoring firm’s overall risk. Thus the VIE creditors remain protected by the specific collateral in the asset. Second, the governing documents can strictly limit the business activities of a VIE. These limits further protect lenders by preventing the VIE from engaging in any activities not specified in its agreements. As a major public accounting firm noted, [t]he borrowertransferor gains access to a source of funds less expensive than would otherwise be available. This advantage derives from isolating the assets in an entity prohibited from undertaking any other business activity or taking on any additional debt, thereby creating a better security interest in the assets for the lenderinvestor. 2 Because governing agreements limit activities and decision making in most VIEs, there is often little need for voting stock. In fact, a sponsoring enterprise may own very little, if any, of its VIE’s voting stock. Prior to current consolidation requirements for VIEs, many businesses left such entities unconsolidated in their financial reports because technically they did not own a majority of the entity’s voting stock. In utilizing the VIE as a conduit to provide financing, the related assets and debt were effectively removed from the enterprise’s balance sheet. Characteristics of Variable Interest Entities Similar to most business entities, VIEs generally have assets, liabilities, and investors with equity interests. Unlike most businesses, because a VIE’s activities can be strictly limited, the role of the equity investors can be fairly minor. The VIE may have been created specifically to benefit its sponsoring firm with low-cost financing. Thus, the equity investors may serve simply as a technical requirement to allow the VIE to function as a legal entity. Because they bear relatively low economic risk, equity investors are typically provided only a small rate of return. LO1 Describe a variable interest entity, a primary beneficiary, and the factors used to decide when a variable interest entity is subject to consolidation. 1 In its 2001 fourth quarter 10-Q, Enron recorded earnings restatements of more than 400 million related to its failure to properly consolidate several of its SPEs e.g., Chewco and LMJ1. Enron also admitted an improper omission of 700 million of its SPE’s debt. Within a month of the restatements, Enron filed for bankruptcy. 2 KPMG, “Defining Issues: New Accounting for SPEs,” March 1, 2002. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 243 The small equity investments normally are insufficient to induce lenders to provide a low-risk interest rate for the VIE. As a result, another party often the sponsoring firm that benefits from the VIE’s activities must contribute substantial resources––often loans andor guarantees––to enable the VIE to secure additional financing needed to accomplish its purpose. For example, the sponsoring firm may guarantee the VIE’s debt, thus assuming the risk of default. Other contractual arrangements may limit returns to equity holders while participation rights provide increased profit potential and risks to the sponsoring firm. Risks and rewards such as these cause the sponsor’s economic interest to vary depending on the created entity’s success––hence the term variable interest entity. In contrast to a traditional entity, a VIE’s risks and rewards are distributed not according to stock ownership but according to other variable interests. Exhibit 6.1 describes variable interests further and provides several examples. Variable interests increase a firm’s risk as the resources it provides or guarantees to the VIE increase. With increased risks come incentives to restrict the VIE’s decision making. In fact, a firm with variable interests will regularly limit the equity investors’ power through the VIE’s governance documents. As noted by GAAP literature, [i]f the total equity investment at risk is not sufficient to permit the legal entity to finance its activities, the parties providing the necessary additional subordinated financial support most likely will not permit an equity investor to make decisions that may be counter to their interests. [FASB ASC para. 810-10-05-13] Although the equity investors are technically the owners of the VIE, in reality they may retain little of the traditional responsibilities, risks, and benefits of ownership. In fact, the equity investors often cede financial control of the VIE to those with variable interest in exchange for a guaranteed rate of return. Consolidation of Variable Interest Entities Prior to current financial reporting standards, assets, liabilities, and results of operations for VIEs and other entities frequently were not consolidated with those of the firm that controlled the entity. These firms invoked a reliance on voting interests, as opposed to variable interests, to indicate a lack of a controlling financial interest. As legacy FASB standard FIN 46R 3 observed, . . . an enterprise’s consolidated financial statements include subsidiaries in which the enterprise has a controlling financial interest. That requirement usually has been applied to subsidiaries in which an enterprise has a majority voting interest, but in many circumstances, the enterprise’s consolidated financial statements do not include variable interest entities with which it has similar relationships. The voting interest approach is not effective in identifying controlling financial interests in entities that are not controllable through voting interests or in which the equity investors do not bear residual economic risk. Summary, page 2 3 FASB Interpretation No. 46R FIN 46R, “Consolidation of Variable Interest Entities,” December 2003. EXHIBIT 6.1 Examples of Variable Interests Variable interests in a variable interest entity are contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity’s net asset value. Variable interests absorb portions of a variable interest entity’s expected losses if they occur or receive portions of the entity’s expected residual returns if they occur. The following are some examples of variable interests and the related potential losses or returns: Variable interests Potential losses or returns • Participation rights • Entitles holder to residual profits • Asset purchase options • Entitles holder to benefit from increases in asset fair values • Guarantees of debt • If a VIE cannot repay liabilities, honoring a debt guarantee will produce a loss • Subordinated debt instruments • If a VIE’s cash flow is insufficient to repay all senior debt, subordinated debt may be required to absorb the loss • Lease residual value guarantees • If leased asset declines below the residual value, honoring the guarantee will produce a loss To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Companies must first identify a VIE that is not subject to control through voting ownership interests but is nonetheless subject to their control and therefore subject to consolidation. Each enterprise involved with a VIE must then determine whether the financial support it provides makes it the primary beneficiary of the VIE’s activities. The VIE’s primary beneficiary is then required to include the assets, liabilities, and results of the activities of the VIE in its consolidated financial statements. Identification of a Variable Interest Entity An entity qualifies as a VIE if either of the following conditions exists: • The total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support provided by any parties, including equity holders. In most cases, if equity at risk is less than 10 percent of total assets, the risk is deemed insufficient. 4 • The equity investors in the VIE, as a group, lack any one of the following three characteristics of a controlling financial interest: 1. The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance. 2. The obligation to absorb the expected losses of the entity e.g., the primary beneficiary may guarantee a return to the equity investors. 3. The right to receive the expected residual returns of the entity e.g., the investors’ return may be capped by the entity’s governing documents or other arrangements with variable interest holders. Identification of the Primary Beneficiary of the VIE Once it is established that a firm has a relationship with a VIE, the firm must determine whether it qualifies as the VIE’s primary beneficiary. The primary beneficiary then must consolidate the VIE’s assets, liabilities, revenues, expenses, and noncontrolling interest. An enterprise with a variable interest that provides it with a controlling financial interest in a variable interest entity will have both of the following characteristics: • The power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance. • The obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity. Note that these characteristics mirror those that the equity investors lack in a VIE. Instead, the primary beneficiary will absorb a significant share of the VIE’s losses or receive a significant share of the VIE’s residual returns or both. The fact that the primary beneficiary may own no voting shares whatsoever becomes inconsequential because such shares do not effectively give the equity investors power to exercise control. Thus, a careful examination of the VIE’s governing documents, contractual arrangements among parties involved, and who bears the risk is necessary to determine whether a reporting entity possesses control over a VIE. The magnitude of the effect of consolidating an enterprise’s VIEs can be large. For example, Walt Disney Company disclosed that two of its major investments qualified as VIEs and that it now will consolidate them. In its 2008 annual report, Disney stated the following: The Company has a 51 percent effective ownership interest in the operations of Euro Disney and a 43 percent ownership interest in the operations of Hong Kong Disneyland which are both consolidated as variable interest entities. As a result of the 2008 consolidation of these two VIEs, Disney’s total assets increased by 5.1 billion while its total debt increased by 3.4 billion. 244 Chapter 6 4 Alternatively, a 10 percent or higher equity interest may also be insufficient. According to GAAP, “Some entities may require an equity investment greater than 10 percent of their assets to finance their activities, especially if they engage in high-risk activities, hold high-risk assets, or have exposure to risks that are not reflected in the reported amounts of the entities’ assets or liabilities.” [FASB ASC para. 810-10-25-46] To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 245 Example of a Primary Beneficiary and Consolidated Variable Interest Entity Assume that Twin Peaks Power Company seeks to acquire a generating plant for a negotiated price of 400 million from Ace Electric Company. Twin Peaks wishes to expand its market share and expects to be able to sell the electricity generated by the plant acquisition at a profit to its owners. In reviewing financing alternatives, Twin Peaks observed that its general credit rating allowed for a 4 percent annual interest rate on a debt issue. Twin Peaks also explored the es- tablishment of a separate legal entity whose sole purpose would be to own the electric generating plant and lease it back to Twin Peaks. Because the separate entity would isolate the electric generating plant from Twin Peaks’s other risky assets and liabilities and provide specific collateral, an interest rate of 3 percent on the debt is available, producing before tax sav- ings of 4 million per year. To obtain the lower interest rate, however, Twin Peaks must guarantee the separate entity’s debt. Twin Peaks must also maintain certain of its own prede- fined financial ratios and restrict the amount of additional debt it can assume. To take advantage of the lower interest rate, on January 1, 2011, Twin Peaks establishes Power Finance Co., an entity designed solely to own, finance, and lease the electric generating plant to Twin Peaks. 5 The documents governing the new entity specify the following: • The sole purpose of Power Finance is to purchase the Ace electric generating plant, provide equity and debt financing, and lease the plant to Twin Peaks. • An outside investor will provide 16 million in exchange for a 100 percent nonvoting equity interest in Power Finance. • Power Finance will issue debt in exchange for 384 million. Because the 16 million equity investment by itself is insufficient to attract low-interest debt financing, Twin Peaks will guarantee the debt. • Twin Peaks will lease the electric generating plant from Power Finance in exchange for payments of 12 million per year based on a 3 percent fixed interest rate for both the debt and equity investors for an initial lease term of five years. • At the end of the five-year lease term or any extension, Twin Peaks must do one of the following: • Renew the lease for five years subject to the approval of the equity investor. • Purchase the electric generating plant for 400 million. • Sell the electric generating plant to an independent third party. If the proceeds of the sale are insufficient to repay the equity investor, Twin Peaks must make a payment of 16 million to the equity investor. Once the purchase of the electric generating plant is complete and the equity and debt are issued, Power Finance Company reports the following balance sheet: 5 This arrangement is similar to a “synthetic lease” commonly used in utility companies. Synthetic leases also can have tax advantages because the sponsoring firm accounts for them as capital leases for tax purposes. POWER FINANCE COMPANY Balance Sheet January 1, 2011 Electric Generating Plant . . . . . . . . 400M Long-Term Debt . . . . . . . . . . . . . 384M Owner’s Equity . . . . . . . . . . . . . . 16M Total Assets . . . . . . . . . . . . . . . . 400M Total Liabilities and OE . . . . . . 400M Exhibit 6.2 shows the relationships between Twin Peaks, Power Finance, the electric generating plant, and the parties financing the asset purchase. In evaluating whether Twin Peaks Electric Company must consolidate Power Finance Com- pany, two conditions must be met. First, Power Finance must qualify as a VIE by either 1 an inability to secure financing without additional subordinated support or 2 a lack of either the To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com risk of losses or entitlement to residual returns or both. Second, Twin Peaks must qualify as the primary beneficiary of Power Finance. In assessing the first condition, several factors point to VIE status for Power Finance. Its owner’s equity comprises only 4 percent of total assets, far short of the 10 percent benchmark. Moreover, Twin Peaks guarantees Power Finance’s debt, suggesting insufficient equity to finance its operations without additional support. Finally, the equity investor appears to bear almost no risk with respect to the operations of the Ace electric plant. These characteristics indicate that Power Finance qualifies as a VIE. In evaluating the second condition for consolidation, an assessment is made to determine whether Twin Peaks qualifies as Power Finance’s primary beneficiary. Clearly, Twin Peaks has the power to direct Power Finance’s activities. But to qualify for consolidation, Twin Peaks must also have the obligation to absorb losses or the right to receive returns from the Power Finance—either of which could potentially be significant to Power Finance. But what possible losses or returns would accrue to Twin Peaks? What are Twin Peaks’s variable interests that rise and fall with the fortunes of Power Finance? As stated in the VIE agreement, Twin Peaks will pay a fixed fee to lease the electric generating plant. It will then operate the plant and sell the electric power in its markets. If the business plan is successful, Twin Peaks will enjoy residual profits from operating while Power Finance’s equity investors receive the fixed fee. On the other hand, if prices for electricity fall, Twin Peaks may generate revenues insufficient to cover its lease payments while Power Finance’s equity investors are protected from this risk. Moreover, if the plant’s fair value increases significantly, Twin Peaks can exercise its option to purchase the plant at a fixed price and either resell it or keep it for its own future use. Alternatively, if Twin Peaks were to sell the plant at a loss, it must pay the equity investors all of their initial investment, furthering the loss to Twin Peaks. Each of these elements points to Twin Peaks as the primary beneficiary of its VIE through variable interests. As the primary beneficiary, Twin Peaks must consolidate the assets, liabilities, and results of operations of Power Finance with its own. Procedures to Consolidate Variable Interest Entities As Power Finance’s balance sheet exemplifies, VIEs typically possess only a few assets and liabilities. Also, their business activities usually are strictly limited. Thus, the actual procedures to consolidate VIEs are relatively uncomplicated. 246 Chapter 6 EXHIBIT 6.2 Variable Interest Entity to Facilitate Financing Financial institution Issues 384 M debt Issues 16 M equity Twin Peaks Electric Co. Power Finance Co. VIE Equity investor Electric Generating Plant Buys and owns Leases and operates plant for profit Fixed lease payments Debt guarantee To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 247 Initial Measurement Issues Just as in business combinations accomplished through voting interests, the financial reporting principles for consolidating variable interest entities require asset, liability, and noncontrolling interest valuations. These valuations initially, and with few exceptions, are based on fair values. Recall that the acquisition method requires an allocation of the acquired business fair value based on the underlying fair values of its assets and liabilities. In determining the total amount to consolidate for a variable interest entity, the total business fair value of the entity is the sum of: • Consideration transferred by the primary beneficiary. • The fair value of the noncontrolling interest. The fair value principle applies to consolidating VIEs in the same manner as business combinations accomplished through voting interests. If the total business fair value of the VIE exceeds the collective fair values of its net assets, goodwill is recognized. 6 Conversely, if the collective fair values of the net assets exceed the total business fair value, then the primary beneficiary recognizes a gain on bargain purchase. In the previous example, assuming that the debt and noncontrolling interests are stated at fair values, Twin Peaks simply includes in its consolidated balance sheet the Electric Generat- ing Plant at 400 million, the Long-Term Debt at 384 million, and a noncontrolling interest of 16 million. As a further example, General Electric Company now consolidates Penske Truck Leasing Company as a VIE. GE recognizes an additional 1.055 billion in goodwill and more than 9 billion in property, plant, and equipment from the Penske consolidation. Previously, Gen- eral Electric’s investment in Penske was accounted for under the equity method. To illustrate the initial measurement issues that a primary beneficiary faces, assume that Vax Company invests 5 million in TLH Property, a variable interest business entity. In agreements completed July 1, 2011, Vax establishes itself as the primary beneficiary of TLH Prop- erty. Previously, Vax had no interest in TLH. After Vax’s investment, TLH presents the following financial information at assessed fair values: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 5 million Land . . . . . . . . . . . . . . . . . . . . . . . . . . 20 million Production facility . . . . . . . . . . . . . . . . 60 million Long-term debt . . . . . . . . . . . . . . . . . 65 million Vax equity investment . . . . . . . . . . . . . 5 million Noncontrolling interest . . . . . . . . . . . . See following for alternative valuations. Vax will initially include each of TLH Property’s assets and liabilities at their individual fair values in its acquisition-date consolidated financial reports. Any excess of TLH Property’s acquisition- date business fair value over the collective fair values assigned to the acquired net assets must be recognized as goodwill. Conversely, if the collective fair values of the acquired net assets exceed the VIE’s business fair value, a “gain on bargain purchase” is credited for the difference. To demonstrate these valuation principles, we use three brief examples, each with a different business fair value depending on alternative assessed fair values of the noncontrolling interest. Total Business Fair Value of VIE Equals Assessed Net Asset Value In this case, assume that the noncontrolling interest fair value equals 15 million. The VIE’s total fair value is then 20 million 5 million consideration paid ⫹ 15 million for the noncontrolling interest. Because the total fair value is identical to the 20 million collective amount of the individually assessed fair values for the net assets 85 million total assets ⫺ 65 million long-term debt, neither goodwill nor a gain on bargain purchase is recognized. Vax simply consolidates all assets and liabilities at their respective fair values. 6 The FASB ASC Glossary defines a business as an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. Alternatively, if the activities of the VIE are so restricted that it does not qualify as a business, the excess fair value is recognized as an acquisition loss, as opposed to goodwill. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Total Business Fair Value of VIE Is Less Than Assessed Net Asset Value Alternatively, assume that the value of the noncontrolling interest was assessed at only 11 million. In this case, TLH Property’s total fair value would be calculated at 16 million 5 million consideration paid ⫹ 11 million for the noncontrolling interest. The 16 million total fair value compared to the 20 million assessed fair value of TLH Property’s net assets including cash produces an excess of 4 million. In essence, the business combination receives a collective 20 million net identifiable asset fair value in exchange for 16 million. In this case, Vax recognizes a gain on bargain purchase of 4 million in its current year consolidated income statement. Total Business Fair Value of VIE Is Greater Than Assessed Net Asset Value Finally, assume that the value of the noncontrolling interest is assessed at 20 million. In this case, the total fair value of TLH Property would be calculated at 25 million 5 million consideration paid ⫹ 20 million for the noncontrolling interest. The 25 million total fair value compared to the 20 million assessed fair value of TLH Property’s net assets produces an excess total fair value of 5 million. Because TLH is a business entity, Vax Company reports the excess 5 million as goodwill in its consolidated statement of financial position. Consolidation of VIEs Subsequent to Initial Measurement After the initial measurement, consolidations of VIEs with their primary beneficiaries should follow the same process as if the entity were consolidated based on voting interests. Impor- tantly, all intra-entity transactions between the primary beneficiary and the VIE including fees, expenses, other sources of income or loss, and intra-entity inventory purchases must be eliminated in consolidation. Finally, the VIE’s income must be allocated among the parties involved i.e., equity holders and the primary beneficiary. For a VIE, contractual arrangements, as opposed to ownership percentages, typically specify the distribution of its income. Therefore, a close examination of these contractual arrangements is needed to determine the appropriate allocation of VIE income to its equity owners and those holding variable interests. Other Variable Interest Entity Disclosure Requirements VIE disclosure requirements are designed to provide users of financial statements with more transparent information about an enterprise’s involvement in a variable interest entity. The enhanced disclosures are required for any enterprise that holds a variable interest in a variable interest entity. Included among the enhanced disclosures are requirements to show: • The VIE’s nature, purpose, size, and activities. • The significant judgments and assumptions made by an enterprise in determining whether it must consolidate a variable interest entity andor disclose information about its involvement in a variable interest entity. • The nature of restrictions on a consolidated variable interest entity’s assets and on the set- tlement of its liabilities reported by an enterprise in its statement of financial position, including the carrying amounts of such assets and liabilities. • The nature of, and changes in, the risks associated with an enterprise’s involvement with the variable interest entity. • How an enterprise’s involvement with the variable interest entity affects the enterprise’s financial position, financial performance, and cash flows. Enterprises that hold a significant variable interest in a VIE but are not the primary beneficiary must also disclose significant quantitative and qualitative information about the VIE and the enterprise’s maximum exposure to loss as a result of its involvement with the VIE. COMPARISONS WITH INTERNATIONAL ACCOUNTING STANDARDS Although IFRS does not specifically mention variable interest entities, Standing Interpreta- tions Committee SIC 12 addresses when a special purpose entity SPE should be consolidated. Similar to variable interest entities, SPEs may be controlled despite a lack of ownership 248 Chapter 6 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 249 interest. If a firm controls an SPE, then it must consolidate it. Control of an SPE by an entity is indicated by the following factors: • The SPE conducts its activities for the benefit of the entity. • The entity has decision-making power over the SPE. • The entity can obtain the majority of the benefits of the SPE’s activities. • The entity has a majority of the ownership risks that arise from the SPE. Examples of SPEs that should be consolidated include entities set up to conduct research and development activities, to provide a leasing arrangement, or to create securities from financial assets. The International Accounting Standards Board has a project on its agenda to reconsider all of its consolidation guidance including guidance for variable interest entities. The ultimate goal of both the FASB and the IASB is to work together to issue guidance that yields similar consolidation and disclosure results for special-purpose entities. Clearly, the FASB wishes to enhance disclosures for all VIEs. Because in the past VIEs were often created in part to keep debt off a sponsoring firm’s balance sheet, these enhanced disclosures are a significant improvement in financial reporting transparency. INTRA-ENTITY DEBT TRANSACTIONS The previous chapter explored the consolidation procedures required by the intra-entity transfer of inventory, land, and depreciable assets. In consolidating these transactions, all resulting gains were deferred until earned through either the use of the asset or its resale to outside parties. Deferral was necessary because these gains, although legitimately recognized by the individual companies, were unearned from the perspective of the consolidated entity. The separate financial information of each company was adjusted on the worksheet to be consistent with the view that the related companies actually composed a single economic concern. This same objective applies in consolidating all other intra-entity transactions: The financial statements must represent the business combination as one enterprise rather than as a group of independent organizations. Consequently, in designing consolidation procedures for intra-entity transactions, the effects recorded by the individual companies first must be isolated. After the impact of each action is analyzed, worksheet entries recast these events from the vantage point of the business combination. Although this process involves a number of nu- ances and complexities, the desire for reporting financial information solely from the perspective of the consolidated entity remains constant. We introduced the intra-entity sales of inventory, land, and depreciable assets together in Chapter 5 because these transfers result in similar consolidation procedures. In each case, one of the affiliated companies recognizes a gain prior to the time the consolidated entity actually earned it. The worksheet entries required by these transactions simply realign the separate financial information to agree with the viewpoint of the business combination. The gain is removed and the inflated asset value is reduced to historical cost. The next section of this chapter examines the intra-entity acquisition of bonds and notes. Although accounting for the related companies as a single economic entity continues to be the central goal, the consolidation procedures applied to intra-entity debt transactions are in dia- metric contrast to the process utilized in Chapter 5 for asset transfers. Before delving into this topic, note that direct loans used to transfer funds between affiliated companies create no unique consolidation problems. Regardless of whether bonds or notes generate such amounts, the resulting receivablepayable balances are necessarily identical. Because no money is owed to or from an outside party, these reciprocal accounts must be eliminated in each subsequent consolidation. A worksheet entry simply offsets the two corresponding balances. Furthermore, the interest revenueexpense accounts associated with direct loans also agree and are removed in the same fashion. LO2 Understand the consolidation procedures to eliminate all intra-entity debt accounts and recognize any associated gain or loss created whenever one company acquires an affiliate’s debt instrument from an outside party. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Acquisition of Affiliate’s Debt from an Outside Party The difficulties encountered in consolidating intra-entity liabilities relate to a specific type of transaction: the purchase from an outside third party of an affiliate’s debt instrument. A parent company, for example, could acquire a bond previously issued by a subsidiary on the open market. Despite the intra-entity nature of this transaction, the debt remains an outstanding obligation of the original issuer but is recorded as an investment by the acquiring company. Thereafter, even though related parties are involved, interest payments pass periodically between the two organizations. Although the individual companies continue to report both the debt and the investment, from a consolidation viewpoint this liability is retired as of the acquisition date. From that time for- ward, the debt is no longer owed to a party outside the business combination. Subsequent interest payments are simply intra-entity cash transfers. To create consolidated statements, worksheet entries must be developed to adjust the various balances to report the debt’s effective retirement. Acquiring an affiliate’s bond or note from an unrelated party poses no significant consolidation problems if the purchase price equals the corresponding book value of the liability. Reciprocal balances within the individual records would always be identical in value and eas- ily offset in each subsequent consolidation. Realistically, though, such reciprocity is rare when a debt is purchased from a third party. A variety of economic factors typically produce a difference between the price paid for the investment and the carrying amount of the obligation. The debt is originally sold under market conditions at a particular time. Any premium or discount associated with this issuance is then amortized over the life of the bond, creating a continuous adjustment to book value. The acquisition of this instrument at a later date is made at a price influenced by current economic conditions, prevailing interest rates, and myriad other financial and market factors. Therefore, the cost paid to purchase the debt could be either more or less than the book value of the liability currently found within the issuing company’s financial records. To the business combination, this difference is a gain or loss because the acquisition effectively re- tires the bond; the debt is no longer owed to an outside party. For external reporting purposes, this gain or loss must be recognized immediately by the consolidated entity. Accounting for Intra-Entity Debt Transactions––Individual Financial Records The accounting problems encountered in consolidating intra-entity debt transactions are fourfold: 1. Both the investment and debt accounts must be eliminated now and for each future consolidation despite containing differing balances. 2. Subsequent interest revenueexpense as well as any interest receivablepayable accounts must be removed although these balances also fail to agree in amount. 3. Changes in all of the preceding accounts occur constantly because of the amortization process. 4. The business combination must recognize the gain or loss on retirement of the debt, even though this balance does not appear within the financial records of either company. To illustrate, assume that Alpha Company possesses an 80 percent interest in the outstanding voting stock of Omega Company. On January 1, 2009, Omega issued 1 million in 10-year bonds paying cash interest of 9 percent annually. Because of market conditions prevailing on that date, Omega sold the debt for 938,555 to yield an effective interest rate of 10 percent per year. Shortly thereafter, the prime interest rate began to fall, and by January 1, 2011, Omega made the decision to retire this debt prematurely and refinance it at the currently lower rates. To carry out this plan, Alpha purchased all of these bonds in the open market on January 1, 2011, for 1,057,466. This price was based on an effective yield of 8 percent, which is assumed to be in line with the interest rates at the time. Many reasons could exist for having Alpha, rather than Omega, reacquire this debt. For example, company cash levels at that date could necessitate Alpha’s role as the purchasing agent. Also, contractual limitations can prohibit Omega from repurchasing its own bonds. 250 Chapter 6 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 251 In accounting for this business combination, an early extinguishment of the debt has occurred. Thus, the difference between the 1,057,466 payment and the January 1, 2011, book value of the liability must be recognized in the consolidated statements as a gain or loss. The exact account balance reported for the debt on that date depends on the amortization process. Although the issue was recorded initially at the 938,555 exchange price, after two years the carrying value increased to 946,651, calculated as follows: 7 Bonds Payable—Book Value—January 1, 2011 Book Effective Interest Cash Year-End Year Value 10 percent rate Interest Amortization Book Value 2009 938,555 93,855 90,000 3,855 942,410 2010 942,410 94,241 90,000 4,241 946,651 Because Alpha paid 110,815 in excess of the recorded liability 1,057,466 ⫺ 946,651, the consolidated entity must recognize a loss of this amount. After the loss has been acknowl- edged, the bond is considered to be retired and no further reporting is necessary by the business combination after January 1, 2011. Despite the simplicity of this approach, neither company accounts for the event in this manner. Omega retains the 1 million debt balance within its separate financial records and amor- tizes the remaining discount each year. Annual cash interest payments of 90,000 9 percent continue to be made. At the same time, Alpha records the investment at the historical cost of 1,057,466, an amount that also requires periodic amortization. Furthermore, as the owner of these bonds, Alpha receives the 90,000 interest payments made by Omega. To organize the accountant’s approach to this consolidation, a complete analysis of the subsequent financial recording made by each company should be produced. Omega records only two journal entries during 2011 assuming that interest is paid each December 31: 7 The effective rate method of amortization is demonstrated here because this approach is theoretically preferable. However, the straight-line method can be applied if the resulting balances are not materially different than the figures computed using the effective rate method. Omega Company’s Financial Records 123111 Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 To record payment of annual cash interest on 1 million, 9 percent bonds payable. 123111 Interest Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,665 Bonds Payable or Discount on Bonds Payable . . . . . . . . . 4,665 To adjust interest expense to effective rate based on original yield rate of 10 percent 946,651 book value for 2011 ⫻ 10 ⫽ 94,665. Book value increases to 951,316. Alpha Company’s Financial Records 1111 Investment in Omega Company Bonds . . . . . . . . . . . . . . . . . . 1,057,466 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,057,466 To record acquisition of 1,000,000 in Omega Company bonds paying 9 percent cash interest, acquired to yield an effective rate of 8 percent. Concurrently, Alpha journalizes entries to record its ownership of this investment: To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 123111 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 To record receipt of cash interest from Omega Company bonds 1,000,000 ⫻ 9. 123111 Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,403 Investment in Omega Company Bonds . . . . . . . . . . . . . . 5,403 To reduce 90,000 interest income to effective rate based on original yield rate of 8 percent 1,057,466 book value for 2011 ⫻ 8 ⫽ 84,597. Book value decreases to 1,052,063. Even a brief review of these entries indicates that the reciprocal accounts to be eliminated within the consolidation process do not agree in amount. You can see the dollar amounts appearing in each set of financial records in Exhibit 6.3. Despite the presence of these recorded balances, none of the four intra-entity accounts the liability, investment, interest expense, and interest revenue appears in the consolidated financial statements. The only figure that the business combination reports is the 110,815 loss created by the extinguishment of this debt. Effects on Consolidation Process As previous discussions indicated, consolidation procedures convert information generated by the individual accounting systems to the perspective of a single economic entity. A worksheet entry is therefore required on December 31, 2011, to eliminate the intra-entity balances shown in Exhibit 6.3 and to recognize the loss resulting from the repurchase. Mechanically, the differences in the liability and investment balances as well as the interest expense and interest income accounts stem from the 110,815 difference between the purchase price of the investment and the book value of the liability. Recognition of this loss, in effect, bridges the gap between the divergent figures. Consolidation Entry B December 31, 2011 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 951,316 Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,597 Loss on Retirement of Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,815 Investment in Omega Company Bonds . . . . . . . . . . . . . . . . . . . . . . . . . 1,052,063 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,665 To remove intra-entity bonds and related interest accounts and record loss on the early extinguishment of this debt. Labeled “B” in reference to bonds. 252 Chapter 6 EXHIBIT 6.3 ALPHA COMPANY AND OMEGA COMPANY Effects of Intra-Entity Debt Transaction 2011 Omega Alpha Company Company Reported Debt Investment 2011 interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,665 –0– 2011 interest income† ; . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 84,597 Bonds payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 951,316 –0– Investment in bonds, 123111† ; . . . . . . . . . . . . . . . . . . . . . –0– 1,052,063 Loss on retirement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– –0– Note: Parentheses indicate credit balances. Company total is adjusted for 2011 amortization of 4,665 see journal entry. †Adjusted for 2011 amortization of 5,403 see journal entry. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 253 The preceding entry successfully transforms the separate financial reporting of Alpha and Omega to that appropriate for the business combination. The objective of the consolidation process has been met: The statements present the bonds as having been retired on January 1, 2011. The debt and the corresponding investment are eliminated along with both interest accounts. Only the loss now appears on the worksheet to be reported within the consolidated financial statements. Assignment of Retirement Gain or Loss Perhaps the most intriguing issue in accounting for intra-entity debt transactions to be ad- dressed concerns the assignment of any gains and losses created by the retirement. Should the 110,815 loss just reported be attributed to Alpha or to Omega? From a practical perspective, this assignment is important only in calculating and reporting noncontrolling interest figures. However, at least four different possible allocations can be identified, each of which demon- strates theoretical merit. First, a strong argument can be made that the liability hypothetically extinguished is that of the issuing company and, thus, any resulting income relates solely to that party. This approach assumes that the retirement of any obligation affects only the debtor. Proponents of this position hold that the acquiring company is merely serving as a purchasing agent for the bonds’ original issuer. Accordingly, in the previous illustration, the benefits derived from paying off the liability should accrue to Omega because refinancing reduced its interest rate. It incurred the loss solely to obtain these lower rates. Therefore, under this assumption, the entire 110,815 is assigned to Omega, the issuer of the debt. This assignment is usually considered to be consistent with the economic unit concept. Second, other accountants argue that the loss should be assigned solely to the investor Alpha. According to proponents of this approach, the acquisition of the bonds and the price negotiated by the buyer created the income effect. A third hypothesis is that the resulting gain or loss should be split in some manner between the two companies. This approach is consistent with both the parent company concept and pro- portionate consolidation. Because both parties are involved with the debt, this proposition con- tends that assigning income to only one company is arbitrary and misleading. Normally, such a division is based on the original face value of the debt. Hence, 57,466 of the loss would be allocated to Alpha with the remaining 53,349 assigned to Omega: Alpha Omega Purchase price . . . . . . . . . . . . 1,057,466 Book value . . . . . . . . . . . . . . . 946,651 Face value . . . . . . . . . . . . . . . 1,000,000 Face value . . . . . . . . . . . . . . . 1,000,000 Loss—Alpha . . . . . . . . . . . . 57,466 Loss—Omega . . . . . . . . . . . 53,349 Allocating the loss in this manner is an enticing solution; the subsequent accounting process creates an identical division within the individual financial records. Because both Alpha’s premium and Omega’s discount must be amortized, the loss figures eventually affect the respective companies’ reported earnings. Over the life of the bond, Alpha records the 57,466 as an interest income reduction, and Omega increases its own interest expense by 53,349 because of the amortization of the discount. A fourth perspective takes a more practical view of intra-entity debt transactions: The parent company ultimately orchestrates all repurchases. As the controlling party in a business combination, the ultimate responsibility for retiring any obligation lies with the parent. The gain or loss resulting from the decision should thus be assigned solely to the parent regardless of the specific identity of the debt issuer or the acquiring company. In the current example, Alpha maintains control over Omega. Therefore, according to this theory, the financial consequences of reacquiring these bonds rest with Alpha so that the entire 110,815 loss must be attributed to it. Each of these arguments has conceptual merit, and if the FASB eventually sets an official standard, any one approach or possibly a hybrid could be required. Unless otherwise stated, however, all income effects in this textbook relating to intra-entity debt transactions are To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com assigned solely to the parent company, as discussed in the final approach. Consequently, the results of extinguishing debt always are attributed to the party most likely to have been responsible for the action. Intra-Entity Debt Transactions––Subsequent to Year of Acquisition Even though the preceding Entry B correctly eliminates Omega’s bonds in the year of retirement, the debt remains within the financial accounts of both companies until maturity. There- fore, in each succeeding time period, all balances must again be consolidated so that the liability is always reported as having been extinguished on January 1, 2011. Unfortunately, a simple repetition of Entry B is not possible. Developing the appropriate worksheet entry is complicated by the amortization process that produces continual change in the various account balances. Thus, as a preliminary step in each subsequent consolidation, current book values, as reported by the two parties, must be identified. To illustrate, the 2012 journal entries for Alpha and Omega follow. Exhibit 6.4 on the following page shows the resulting account balances as of the end of that year. WHO LOST THIS 300,000? Several years ago, Penston Company purchased 90 percent of the outstanding shares of Swansan Corporation. Penston made the acquisition because Swansan produced a vital component used in Penston’s manufacturing process. Penston wanted to ensure an ade- quate supply of this item at a reasonable price. The former owner, James Swansan, retained the remaining 10 percent of Swansan’s stock and agreed to continue managing this organization. He was given responsibility for the subsidiary’s daily manufacturing operations but not for any financial decisions. Swansan’s takeover has proven to be a successful undertaking for Penston. The subsidiary has managed to supply all of the parent’s inventory needs and distribute a variety of items to outside customers. At a recent meeting, Penston’s president and the company’s chief financial officer began discussing Swansan’s debt position. The subsidiary had a debt-to-equity ratio that seemed unreasonably high considering the significant amount of cash flows being generated by both companies. Payment of the interest expense, especially on the subsidiary’s outstanding bonds, was a major cost, one that the corporate officials hoped to reduce. However, the bond indenture specified that Swansan could retire this debt prior to maturity only by paying 107 percent of face value. This premium was considered prohibitive. Thus, to avoid contractual problems, Penston acquired a large portion of Swansan’s liability on the open market for 101 percent of face value. Penston’s purchase created an effective loss of 300,000 on the debt, the excess of the price over the book value of the debt, as reported on Swansan’s books. Company accountants currently are computing the noncontrolling interest’s share of consolidated net income to be reported for the current year. They are unsure about the impact of this 300,000 loss. The subsidiary’s debt was retired, but officials of the parent company made the decision. Who lost this 300,000? Discussion Question Omega Company’s Financial Records—December 31, 2012 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 To record payment of annual cash interest on 1 million, 9 percent bonds payable. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,132 Bonds Payable or Discount on Bonds Payable . . . . . . . . . . . . . . . . . . 5,132 To adjust interest expense to effective rate based on an original yield rate of 10 percent 951,316 book value for 2012 ⫻ 10 ⫽ 95,132. Book value increases to 956,448. 254 To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 255 After the information in Exhibit 6.4 has been assembled, the necessary consolidation entry as of December 31, 2012, can be produced. This entry removes the balances reported at that date for the intra-entity bonds, as well as both of the interest accounts, to reflect the extinguishment of the debt on January 1, 2011. Because retirement occurred in a prior period, the worksheet adjustment must also create a 110,815 reduction in Retained Earnings to represent the original loss, but net of prior year’s discount and premium amortizations. Analysis of this latest consolidation entry should emphasize several important factors: 1. The individual account balances change during the present fiscal period so that the current consolidation entry differs from Entry B. These alterations are a result of the amortization process. To ensure the accuracy of the worksheet entry, the adjusted balances are isolated in Exhibit 6.4. 2. As indicated previously, all income effects arising from intra-entity debt transactions are assigned to the parent company. For this reason, the adjustment to beginning Retained Earn- ings in Entry B is attributed to Alpha as is the 10,967 increase in current income EXHIBIT 6.4 ALPHA COMPANY AND OMEGA COMPANY Effects of Intra-Entity Debt Transactions 2012 Alpha Omega Company Company Reported Debt Investment 2012 interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,132 –0– 2012 interest income† . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 84,165 Bonds payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 956,448 –0– Investment in bonds, 123112† . . . . . . . . . . . . . . . . . . . . . –0– 1,046,228 Income effect within retained earnings, 1112‡ . . . . . . . . . 94,665 84,597 Note: Parentheses indicate credit balances. Company total is adjusted for 2012 amortization of 5,132 see journal entry. †Adjusted for 2012 amortization of 5,835 see journal entry. ‡ The balance shown for the Retained Earnings account of each company represents the 2011 reported interest figures. Alpha Company’s Financial Records—December 31, 2012 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 To record receipt of cash interest from Omega Company bonds. Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,835 Investment in Omega Company Bonds . . . . . . . . . . . . . . . . . . . . . . . . 5,835 To reduce 90,000 interest income to effective rate based on an original yield rate of 8 percent 1,052,063 book value for 2012 ⫻ 8 ⫽ 84,165. Book value decreases to 1,046,228. Consolidation Entry B December 31, 2012 Bonds Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 956,448 Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84,165 Retained Earnings, 1112 Alpha . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,747 Investment in Omega Company Bonds . . . . . . . . . . . . . . . . . . . . . . . 1,046,228 Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,132 To eliminate intra-entity bond and related interest accounts and to adjust Retained Earnings from 10,068 currently recorded net debit balance to 110,815. Labeled “ B“ in reference to prior year bond transaction. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com 95,132 interest expense elimination less the 84,165 interest revenue elimination. 8 Con- sequently, the noncontrolling interest balances are not altered by Entry B. 3. The 2012 reduction to beginning Retained Earnings in Entry B 100,747 does not agree with the original 110,815 retirement loss. The individual companies have recorded a net deficit balance of 10,068 the amount by which previous interest expense exceeds interest revenue at the start of 2012. To achieve the proper consolidated total, an adjustment of only 100,747 is required 110,815 ⫺ 10,068. Retained earnings balance—consolidation perspective loss on retirement of debt . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,815 Individual retained earnings balances, 1112: Omega Company interest expense—2011. . . . . . . . . . . . . . . 94,665 Alpha Company interest income—2011 . . . . . . . . . . . . . . . . 84,597 10,068 Adjustment to consolidated retained earnings, 1112. . . . . . . . . 100,747 Parentheses indicate a credit balance. The periodic amortization of both the bond payable discount and the premium on the investment impacts the interest expense and revenue recorded by the two companies. As this schedule shows, these two interest accounts do not offset exactly; a 10,068 net residual amount remains in Retained Earnings after the first year. Because this balance continues to increase each year, the subsequent consolidation adjustments to record the loss decrease to 100,747 in 2012 and constantly lesser thereafter. Over the life of the bond, the amortization process gradually brings the totals in the individual Retained Earnings accounts into agreement with the consolidated balance.

4. Entry B as shown is appropriate for consolidations in which the parent has applied either

the initial value or the partial equity method. However, a deviation is required if the parent uses the equity method for internal reporting purposes. Properly applying the equity method ensures that the parent’s income and, hence, its retained earnings are correctly stated prior to consolidation. Alpha would have already recognized the loss in accounting for this investment. Consequently, when the parent applies the equity method, no adjustment to Retained Earnings is needed. In this one case, the 100,747 debit in Entry B is made to the Invest- ment in Omega Company instead of Retained Earnings because the loss has become a component of that account. SUBSIDIARY PREFERRED STOCK Although both small and large corporations routinely issue preferred shares, their presence within a subsidiary’s equity structure adds a new dimension to the consolidation process. What accounting should be made of a subsidiary’s preferred stock and the parent’s payments that are made to acquire these shares? Recall that preferred shares, although typically nonvoting, possess other “preferences” over common shares such as a cumulative dividend preference or participation rights. Preferred shares may even offer limited voting rights. Nonetheless, preferred shares are considered as a part of the subsidiary’s stockholders’ equity and their treatment in the parent’s consolidated financial reports closely follows that for common shares. The existence of subsidiary preferred shares does little to complicate the consolidation process. The acquisition method values all business acquisitions whether 100 percent or less than 100 percent acquired at their full fair values. In accounting for the acquisition of a subsidiary with preferred stock, the essential process of determining the acquisition-date business fair value of the subsidiary remains intact. Any preferred shares not owned by the parent 256 Chapter 6 8 Had the effects of the retirement been attributed solely to the original issuer of the bonds, the 10,967 addition to current income would have been assigned to Omega the subsidiary, thus creating a change in the noncontrolling interest computations. LO3 Understand that subsidiary preferred stocks not owned by the parent are a component of the noncontrolling interest and are initially valued at acquisition-date fair value. To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 257 simply become a component of the noncontrolling interest and are included in the subsidiary business fair-value calculation. The acquisition-date fair value for any subsidiary common andor preferred shares owned by outsiders becomes the basis for the noncontrolling interest valuation in the parent’s consolidated financial reports. To illustrate, assume that on January 1, 2011, High Company acquires control over Low Company by purchasing 80 percent of its outstanding common stock and 60 percent of its nonvoting, cumulative, preferred stock. Low owns land undervalued in its records by 100,000, but all other assets and liabilities have fair values equal to their book values. High paid a purchase price of 1 million for the common shares and 62,400 for the preferred. On the acquisition date, the 20 percent noncontrolling interest in the common shares had a fair value of 250,000 and the 40 percent preferred stock noncontrolling interest had a fair value of 41,600. Low’s capital structure immediately prior to the acquisition is shown below: Common stock, 20 par value 20,000 shares outstanding . . . . . . . . . . . . . . . 400,000 Preferred stock, 6 cumulative with a par value of 100 1,000 shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516,000 Total stockholders’ equity book value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,216,000 Exhibit 6.5 shows High’s calculation of the acquisition-date fair value of Low and the allocation of the difference between the fair and book values to land and goodwill. As seen in Exhibit 6.5, the subsidiary’s ownership structure i.e., comprising both preferred and common shares does not affect the fair-value principle for determining the basis for consolidating the subsidiary. Moreover, the acquisition method follows the same procedure for calculating business fair value regardless of the various preferences the preferred shares may possess. Any cumulative or participating preferences or any additional rights attributed to the preferred shares are assumed to be captured by the acquisition-date fair value of the shares and thus automatically incorporated into the subsidiary’s valuation basis for consolidation. By utilizing the information above, we next construct a basic worksheet entry as of Janu- ary 1, 2011 the acquisition date. In the presence of both common and preferred subsidiary shares, combining the customary consolidation entries S and A avoids an unnecessary allocation of the subsidiary’s retained earnings across these equity shares. The combined EXHIBIT 6.5 LOW COMPANY Acquisition-Date Fair Value January 1, 2011 Consideration transferred for 80 interest in Low’s common stock . . 1,000,000 Consideration transferred for 60 interest in Low’s preferred stock . 62,400 Noncontrolling interest in Low’s common stock 20 . . . . . . . . . . . 250,000 Noncontrolling interest in Low’s preferred stock 40 . . . . . . . . . . . 41,600 Total fair value of Low on 1111 . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,354,000 HIGH’S ACQUISITION OF LOW Excess Fair Value Over Book Value Allocation January 1, 2011 Low Company business fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,354,000 Low Company book value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,216,000 Excess acquisition-date fair value over book value . . . . . . . . . . . . . . . 138,000 Assigned to land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Assigned to goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000 138,000 –0– To download more slides, ebook, solutions and test bank, visit http:downloadslide.blogspot.com

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